How to Use Debt to Scale Startups

Many startup founders start their companies chasing venture capital. They have wild dreams of raising millions and creating unicorn companies.

In reality, less than 0.05% of companies raise venture capital.

That is 1 in 2000 companies.

Instead, most companies raise a little money through friends and family, angel investors, or debt.

The good news is that starting a new company has never been easier and more affordable. AI-powered tools are helping startup founders do more with less than ever before. Leveraging global talent also makes hiring software developers and other roles much more affordable.

We are now in a world where companies are raising less money and often doing only one small round of funding.

Debt has emerged as a more viable and attractive option for fueling growth. I personally used $2 million in debt at one of my SaaS companies to fuel growth which led to a successful exit.

I recently had Keith Harrington, an expert in debt financing, on the podcast. His company, Novel Capital, is one of the pioneers in helping startups obtain debt financing.

You can listen to the Startup Hustle on your podcast app or watch the episode on YouTube!

Keith helped educate me and our listeners on all the different types of debt and the pros and cons. If you are considering raising capital, you need to listen to this episode!

Lets dive into what you need to know about debt financing for startups.

When to Consider Debt Financing

Debt financing can be an excellent tool for startups looking to scale without diluting ownership. Here are some scenarios where debt might be the right choice:

1. Bridging short-term cash flow gaps: When you need to cover operational expenses or take advantage of time-sensitive opportunities.

2. Funding specific growth initiatives: Such as hiring key personnel or investing in marketing campaigns with predictable returns.

3. Expanding operations: When you need capital to purchase equipment, inventory, or open new locations.

4. Accelerating growth: If you have a proven business model and need capital to scale faster.

While these scenarios highlight when debt financing might be appropriate, it's crucial to weigh the advantages and disadvantages of debt against other financing options, particularly equity.

Keith Harrington states, "Every CEO we talk to has the same questions. Is debt the right answer for me? Should I be raising equity?"

Understanding the pros and cons of each approach can help you make an informed decision that aligns with your company's goals and financial situation.

Let's break down the key differences between debt and equity financing to give you a clearer picture.

Debt financing pros and cons

Equity financing pros and cons

When weighing these options, debt financing offers significant advantages for startups looking to maintain control and maximize long-term value.

Using debt keeps you from the headaches of new investors, a potential board, and the long-drawn out fundraising process.

Moreover, the cost of debt is often lower than equity in the long run.

Keith puts it well: "The better you do, the more expensive equity gets." With debt, you can fuel growth and reap the full rewards of your success without giving away a slice of your company's future value.

Types of Debt Financing for Startups

1. Revenue-Based Financing: Repayments are tied to monthly revenue, usually a fixed percentage. This is ideal for companies with steady, predictable revenue streams.

2. Term Loans: Traditional loans with fixed repayment schedules. These are suitable for companies with stable cash flows and clear growth plans.

3. Lines of Credit: Flexible borrowing options that allow you to draw funds as needed. Perfect for managing cash flow fluctuations or seizing unexpected opportunities.

4. Equipment Financing: Loans specifically for purchasing equipment, with the equipment itself serving as collateral.

5. Invoice Financing: Allows you to borrow against unpaid invoices, helping to smooth out cash flow in B2B businesses with longer payment cycles.

6. Merchant Cash Advances: Quick access to cash, repaid through a percentage of daily credit card sales. Stripe and others offer this. Warning: this can be a major drain on short term cash flow when paying back.

My Experience with Debt Financing

At Stackify, we raised $2 million in debt financing, which proved critical to our success and eventual exit in 2021. We never raised any money from traditional venture capital investors!

This decision allowed us to retain more equity and control over our company. As I mentioned in the podcast, "We had a hard time finding any institutional investors that wanted to invest. Debt providers are more interested because they inherently have a little less risk because they have to be paid back first."

This experience taught me that debt can be an excellent tool for growth when used strategically. It provided us with the capital we needed to scale without the pressure of giving up significant equity or control to outside investors.

Red Flags to Watch Out For

While debt can be a powerful tool, it's crucial to approach it cautiously. Here are some red flags to be aware of:

1. Predatory Terms: Be wary of lenders offering terms that seem too good to be true. As Keith warns, "Be really cognizant of the repayment structure. Understand exactly how that's going to work."

2. Excessive Borrowing: Taking on more debt than your cash flow can support can strangle your growth. As I often say, "The more money you raise, the bigger bet that you're making."

3. Misaligned Repayment Structures: As Keith advises, "Don't take a three-year loan to solve a 90-day problem. You also wouldn’t take a 90-day loan to solve a three-year growth problem."

4. Hidden Fees or Penalties: Always read the fine print and understand all costs associated with the loan.

5. Personal Guarantees: Be cautious about loans requiring personal guarantees, as they put your personal assets at risk.

6. Warrants or Equity Kickers: Some lenders may ask for warrants or equity in addition to interest. As Keith points out, "All of a sudden somebody who owns 2% gets a meaningful slug and you're like, I wish I hadn't done that."

Remember, the right debt strategy should fuel growth, not hinder it. 

It's crucial to have a clear plan for how you'll use the funds and how you'll repay them.

The Novel Capital Approach

Keith’s company, Novel Capital offers a unique approach to debt financing for startups. As Keith explains, "We provide a two to three year growth loan. The payback structure is you have a smaller payment in year one, a larger payment in year two, kind of giving you the opportunity to grow into payments."

What sets Novel Capital apart is its focus on the company's growth potential rather than traditional collateral.

They don't require personal guarantees, which is a significant advantage for many entrepreneurs. As Keith puts it, "We got really focused on, let's just make sure we get really good at underwriting the business. And if we mess that up, that's on us, but we're not gonna come after your house."

Novel Capital also offers tools to help startups navigate the complex world of financing. Their "Venture Match" tool, for instance, helps connect startups with potential equity investors based on data-driven matches.

That is super cool!!!

As a new partner of Startup Hustle, we highly recommend Novel Capital for startups looking for growth financing. Their approach aligns well with the needs of modern, growth-focused startups.

Why partner with Novel Capital?

• Non-Dilutive Capital: Secure up to $5M in funding without giving up equity, allowing you to maintain full control of your company.

• Quick Access to Funds: Get the capital you need in days, not months, and eliminate the usual fundraising headaches.

• Tech Industry Expertise: With over $85M provided to more than 120 SaaS and tech companies, Novel Capital deeply understands the challenges of scaling in the tech industry

Exclusive Offer for Startup Hustle fans:

As part of Full Scale’s partnership, you’re eligible for a $1000 discount on platform fees when you sign up with Novel Capital.

Don’t let funding challenges hold you back! Sign up here to explore how Novel Capital can help you scale your business faster and smarter.

Conclusion

There are many ways to raise capital, and every business leader should consider debt when it makes sense. Whether you need to bridge short-term issues or fuel growth through key hires and strategic investments, debt can be a valuable tool in your financial toolkit.

At Full Scale, we used similar small loans of $100,000-$200,000 to help bridge working capital gaps in the past. During the pandemic, for example, tapping into debt financing was crucial to bridging the gap and ensuring our company's survival and continued growth.

As Keith wisely advises, "Make sure that when you are raising debt capital or credit facility, make sure that it fits your use of funds."

By carefully considering your needs, scrutinizing the terms, and having a clear plan for using and repaying the funds, debt financing can be a powerful lever for scaling your startup without sacrificing ownership or control.

Remember, the goal is sustainable growth.

Whether through debt, equity, or a combination of both, the key is to choose the financing option that best aligns with your company's unique needs and growth trajectory. If you are considering using debt, definitely check out Keith with Novel Capital!

Big thanks to Keith for being on the podcast!