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Why Are Startups Still Opting for Debt Financing Despite Risks

Mans hand drawing Startup concept on white notebook

The last few years have witnessed a tremendous amount of venture funding, particularly for the startups. Almost $67 billion was disbursed through almost 6370 completed deals in 2017 for startups based in the U.S.A.  Propped-up valuations have accompanied a sharp rise in deal activity, making things quite difficult for the startups.

Even though debt seems quite fascinating and enticing for a host of reasons, it may be accompanied by a certain degree of risk. If a startup fails to attain the degree of growth forecasted, the debt would be just like a time bomb rather than growth equity.

With the startup bubble reaching its peak, securing funding via venture capital, angel investment, or private equity is becoming tougher and tougher. On the other hand, banks and other private financial institutions are now realizing the value of startups and are providing an easy way out through debt financing. If managed well, debt finance could provide the boost you need to achieve your goals, but as with most cases, it can snowball into a pretty messy situation that drags both you and your company into trouble.

Dangers Associated with Debt Financing

Tremendously High Rates: Startups have a degree of risk associated with them, which tempts lenders to hike their interest rates to ensure that they earn solid dividends on their investment and also are able to recoup as much of it as possible in case of a defaulter. Although interest can be discounted from tax deductions, the rates depend on your personal and business credit rating, economic conditions, and so on.

The Obligation to Repay: Your lender expects repayment at all costs. This means that even if your business has failed and you are in a dire financial situation, you will be obligated to repay the loan in full. Lenders are also typically the first to pounce and make a repayment claim and pile the pressure on you in case you are forced to declare bankruptcy.

Collateral and Cash Flow: Whatever be the reason you are taking out a loan for your startup, you will need a sufficient and steady cash flow when the repayment period begins. Further, you are likely expected to put up some form of collateral as security in case you default on payments.

Affect Credit Rating: Debt in any form is very attractive because it is relatively easy to acquire and provides a quick fix to your immediate funding problems. The prospect of leveraging up is tempting for any startup, but every loan taken delivers a hit to your credit rating that isn’t too easy to shake off. While repaid debt actually improves your credit history and makes you a favorable borrower, you are viewed as a big risk if you have a history of borrowing extensively, and also have a lot of outstanding debt. This means you will end up paying much higher interest rates on subsequent loans.

A Case in Favor of Debt Financing

Every time a startup would succeed, it would be aspiring for more accomplishments in the years to come. Moreover, at present, your success is measured by the capital you have registered in your accounting books. Numerous startups are unable to take remedial steps for raising funds optimally. So high-interests would be reducing their profit margins and further add to their liabilities. Numerous businesspersons are of the opinion that equity is actually a relatively cheaper finance source but as per qualified chartered accountants, there are several occasions when the debt would actually be much cheaper and better source of finance.

You must appreciate that debt financing actually help new startups in paying for assets, equipment, and buildings, much before the estimated earnings start materializing. Hence, this could be an outstanding way of pursuing an effective and truly aggressive growth strategy, particularly with access to the relatively low-interest rates. In comparison with equity financing, certain advantages could be enjoyed by not giving away any control or ownership of your business.

Conclusion 

You must never stop thinking big, keep exploring innovative, as well as, novel ideas and do not worry about the rest. Debt financing is actually the cornerstone of your business success provided you could boast of an impressive credit rating. You must necessarily possess the discipline to come up with the repayments timely.

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