Although debatable, the best and easiest way to start your business in today’s highly connected technology world is to bootstrap together a minimal viable product at zero outside investment.
How do you do this? First, it’s about having a founding team that is made up of builders, designers, and sellers. Second, it’s about having a dedicated team that is willing to work for nothing, but invest everything (time, money, and to give up other opportunities). Lastly, having a bit of capital in your back pocket to feed yourself ramen and hot dogs can also go a long way.
So what do you do when you don’t have one of these ingredients to bootstrap your startup? – You begin considering outside funding.
There are a few main forms of outside funding that are available. There are those that are awarded – grants and bursaries. There are those that are private investments for a stake in the company, typically classified as an equity investment (seed funding, series funding, or public market funding). And last, there are those associated with debt based financing which is what this blog will focus on explaining in more depth.
I’d like to first highlight that if funding through the other two categories is available (eg. friends and family equity funding) then by all means take the investment. However, when the going gets tough, and funding from other resources is scarce, banks are generally still around the corner.
Compared to equity, the interest rate on debt is minuscule. With the current expectation of a 10x return in 5-10 years, the expected internal rate of return of an equity investment would require a startup to pay the equivalent of 26-58% to investors. There are several low interest options currently available to entrepreneurs. One example is the Canadian Youth Business Foundation’s financing program for up to $45,000 at prime + 3%.
If you’ve ever applied for grants or sought capital investment, you understand how long the process is. You also know that many times after rounds of applications and due diligence, that your startup just doesn’t qualify or things “just don’t work out”. Debt is different; you have very defined resources that you can reach out to for financing. Whether or not you qualify for a loan or line of credit is also a very well defined process.
Debt allows you to remain in control of the direction of your company. Grants are restrictive in what the funds can be used for, and equity investments could turn into a full-blown hostile takeover.
Collateral is generally required to reduce the bank’s risk when requesting larger loans. Cash flow is immensely important. If your product has a long development cycle and you can’t personally finance interest payments, then debt may be a very difficult funding option.
Debt shouldn’t be dismissed without consideration. There are many valid and rational reasons as to why debt should be considered, but always within the context of each entrepreneur’s situation.