To Grow Your Small Business, Consider Debt First

Many small to mid-size business owners dream of landing a deal with venture capital firms. Equity investments can give companies a great boost of growth. However, less than 1% of American startups successfully raise VC money in a given year.

Before you start chasing what may be exceptionally difficult money to raise, it’s worthwhile to step back and examine how raising VC money would fit in with your long-term business plans. What are the expectations and consequences that come from taking large equity investments? And how will that impact your business?

You may find that VC money, or equity in general, isn’t the best fit for your organization at this point in time. Fortunately, there’s another great capital option for SMB founders: debt. Debt is typically more available and less expensive than equity. It also doesn’t require the owners to give up as much control.

Here are five considerations to keep in mind when thinking about getting debt for your business.

1. Debt is straightforward and less expensive. 

Compared to equity, debt is both more straightforward and less expensive. Just like with a car loan or a home mortgage, you’ll have a fixed amount to pay every month, so there are no surprises or unintended consequences. By contrast, when you offer equity in exchange for capital, you lack clarity on just how much you’re paying for that capital, since the value of the shares you offer fluctuates along with the value of your business.

VCs typically invest in companies looking for a 5-10x return over a 5-7 year period. If your company does become successful, the equity you’ve given away will be much more costly than debt.

2. Build relationships with local bankers.

Many smaller businesses struggle to get substantial bank loans. Bankers want to secure loans with collateral, but many small businesses lack sufficient hard assets. In cases like this, bankers will require founders to personally guarantee loans with their own assets, such as their home, savings, or retirement accounts. While this may seem risky, you shouldn’t let it deter you from considering a bank loan, since this will be, by far, the least expensive money you can get.

Keep in mind that the process of securing a bank loan can take many months, and bankers may want you to step back and build your company up a bit more before qualifying you for a loan.

Because the process is so relationship-driven, it pays to build relationships with local bankers. With a strong relationship, you’ll get valuable assistance in walking through the process. Local banks want to help small businesses in their community succeed, and once you earn their trust and respect, they’ll be more likely to help you figure out what it takes to get the funding you need.

3. Be wary of online lenders and merchant cash advances.

Quick cash can be costly. That’s why you should reserve using an online lender or a merchant cash advance for emergencies only. Use quick cash only if you need to make payroll or survive a temporary cash crunch. When it comes to the daily expenses of running a company — let alone trying to grow business — the quick cash options are simply far too expensive. Many of them charge interest rates between 50-100%!

One reason the effective interest rates are so high is that these quick-cash loans require you to pay back the loan on a weekly or even daily schedule, typically starting immediately after you take out the loan. Not only does that dramatically increase the effective APR, it also impacts your future cash flow, which is critical to funding growth for your business.

Before you take on any non-traditional forms of debt, determine the true cost of the alternative debt arrangement you’re considering (check out this effective APR calculator).

4. Venture debt may be out of reach.

In order to get venture debt, the first requirement is to be venture-backed. But becoming a venture-funded company isn’t easy. It’s a select club with rigorous membership standards. You need to have a well-established company with at least $5 million dollars in annual revenue before most VCs will even consider investing. In addition, you’ll need to convince one of the top VC firms that they should partner with you; without that sort of backing, it’ll be almost impossible to get any large investors.

Fortunately, once you reach the magic $5M annual revenue mark, traditional lenders will be far more likely to consider you. In addition, you’ll also qualify for some of the newer loan options that are based on monthly recurring revenue, such as AR factoring and MRR lines, which further expand your options for growth capital.

5. Be wary of convertible debt.

One popular way for early-stage startups to raise money is convertible debt, which combines both debt and equity options into one. Initially, it’s simply a debt instrument, but if your company reaches certain milestones (such as raising more money), the debt converts to equity.

The potential problem with convertible debt is that it combines the downsides of debt with the downsides of equity. If you reach your milestones, the convertible debt investor gets to buy equity at a discount (typically 20% to 25% off), because those were the terms that lured them in in the first place. But if you fail to meet your milestones with the preset time horizon (typically 12 to 18 months), then you’re on the hook to convertible debt holders principle plus interest, all in one large payment. This can negatively impact your cash flow, hindering your chances of securing a new loan.

6. Before you raise any money, ask yourself some key questions.

Which funding options are right for you will depend on your company’s stage, the amount of money you need, and what you’re willing to give up to get that money.

Before you make any big financing decisions, step back and think hard about what kind of company you want to build. Good questions to ask include:

• What are my long-term goals for my company?
• How much control do I want to maintain?
• How much risk am I willing to take?
• Do I want to work with outside investors?

For more information, check out this guide on How to Choose the Best Funding Path For Your Startup, where we’ll walk you through these questions and more.