Understanding the Risk of Debt Financing

Do the Benefits Outweigh the Risks?

risk-of-debt-financingThere are many benefits of debt financing. Staying in control of your business’ day-to-day operations as well as its long-term goals. Regaining control of your business if equity is already in employees’ or investors’ hands. Extending your cash runway between fundraising rounds. Supplementing an existing strong cash flow to launch a new phase of growth.

These are just a few of the many debt financing advantages SaaS owners can enjoy by going this route to secure capital. And while the perks are many, there are risks associated with debt financing. We’ve outlined a few of the risks of debt financing to ensure you are well informed when weighing your options.

Yes, the Interest Rate is High, But…

If you do your research, you’ll notice the interest rate associated with debt financing often surprises people. You’ll see rates from 14 percent to the low 20s. So why do companies take on debt with an interest rate that high? Well, there are some significant advantages to going this route rather than choosing an equity investor.

In our benefits of debt post, we highlighted an example of what your takeaway as an owner might be with debt financing versus equity financing. In this example, a $2 million loan plus interest had to be repaid, whereas nothing had to be repaid to the equity investor. However, because that investor owned a portion of the company, they were owed a certain amount of money when the company sold for $50 million.

The equity investor takeaway was nearly $6 million more than the $2.9 million debt repayment. The owner takeaway was that much less.

With Venture Debt, Collateral Requirements are Different

If you tried to obtain working capital through a bank loan, you’d find their collateral requirements might be assets such as property, equipment, other funds, and so on. As a growing SaaS company, those assets simply might not be available to you. Sure, you have the equipment, but it’s probably not enough to serve as collateral. With SaaS companies, the real value is the intellectual property.

If your SaaS business already has strong cash flow and sticky subscribers, using intellectual property as collateral might be a risk you’re willing to take. Maybe you need the working capital not to extend your cash runway, but to invest in a new growth strategy that includes previously unused marketing platforms and tactics as well as a bolstered sales team.

In this situation, your foundation may be solidified well enough that using IP as collateral isn’t much of a risk. Of course, this is a risk of debt financing that’s highly subjective and dependent on your risk appetite.

How You Structure Your Loan Matters

Debt financing features negotiability and flexibility in that you can work with your lender to structure the loan. This might be how funds are needed, where your company stands and where it’s projected to be, and what the financing goal is.

Work with your lender to determine the best loan structure based on payments you can afford now versus later. These might include a step-up structure, balloon payments, and others. Ultimately, the most advantageous use of debt financing is for expediting growth. Work with your lender to structure your loan in the way that best helps you achieve your goals.

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