Alternative debt funding vs. traditional debt funding: All you need to know

Sep 11, 2023

In the business world, whether steering a SaaS startup, an SME, or a big corporation, one thing is certain: funding is essential. It fuels growth, powers investments, and keeps the operation running. So, how do you secure funds, especially for your SaaS company? Well, there is a duo of avenues to explore: the inner workings of your company and the world outside.

With internal financing, companies keep the financial resources from their own business within the company, for instance profits or accruals. Then, there is external funding, where companies tap into sources beyond their walls. In the case of debt, the best-known external source is a bank loan. However, various alternative debt funding instruments have emerged in recent years.

The basics of debt funding

Debt financing provides capital from third parties, such as banks or other financial institutions. In addition to repaying the principal, the company pays interest regularly over a specific period of time. Today, companies can choose between different interest models and payment methods, such as monthly, quarterly, annual, or pay-in-kind loans.

Now, let’s break it down further with the advantages and disadvantages of debt funding. 

The upsides of debt

  • No seat at the table: Debt-funded companies are more independent. There are no co-determination rights for the capital providers.
  • No participation: Debt capital providers do not participate in profits or losses. They get back what they lent, including interest. 
  • Cost aware: The cost of capital for debt is known. The interest rates are contractually fixed in advance, which makes planning and optimizing the capital costs easier.

The downsides of debt

  • Costs: Debt capital guarantees capital costs.
  • Unwavering duty: Even if the business does not develop as expected, the company has to pay interest.
  • Time-limited: Debt is only available for a limited period of time.

Traditional debt funding

In theory, debt funding is open to all companies regardless of industry or size. The reality looks different. Traditional debt funding, viewed through the lens of banks and established financial institutions, tends to favor established companies. 

What do they have in common? They have tangible assets (machines, real estate, vehicle fleet), are usually profitable, and have a business model that checks the boxes banks are familiar with.

Traditional debt funding isn’t available for everyone

All of this has its place and works well for many companies. But it does not apply to all businesses out there. In fact, it is much more difficult for SaaS startups and early-stage companies, especially in the tech space, to raise capital from a traditional bank. They often lack tangible assets, are not (yet) profitable, and have, in most cases, a business model that is outside the classic approach of a bank. 

Though, debt is not a dead end for startups. It is a road that goes far beyond the bank’s doorstep. For SaaS startups, the “one-size-fits-all” approach is not suitable. Instead, they must look beyond traditional debt providers and focus on alternative debt funding

Alternative debt funding for startups

Before entering the debt world, founders must carefully evaluate their funding needs and objectives. They need to understand the eligibility criteria and requirements to identify the funding solution that fits their business: 

  • What do I need the capital for? 
  • How much money do I need? 
  • How much risk do I want to take? 
  • What are the terms and conditions?

Regardless of the answers to these questions, SaaS startups must be cautious when considering debt funding. It is important to remember that taking on debt means paying interest. 

Now, let’s have a look at what is beyond the bank’s doorstep.

Large volumes, large burdens: Venture Debt 

Venture debt is a type of external cash, similar to a traditional bank loan but with greater accessibility for startups. It fits mature startups that have generated revenue, secured VC investments, and are profit-oriented.

Venture debt can be a great strategic runway extension for startups. Picture this: You gain more time to hit crucial financial milestones, maneuvering toward a better position for the next funding round. It is also worth noting that venture debt can provide larger volumes than most other alternative debt funding options. And, unlike long-term loans (one to ten years), venture debt is typically repaid over up to three years. 

Venture Debt: Not necessarily non-dilutive

Yet, founders have to be careful when opting for venture debt. Many often state that this form of debt is non-dilutive. However, this is not always the case. Venture debt funds may require warrants (security that entitles a holder to buy or sell shares to a fixed price) as part of the contract, which could lead to dilution. Similarly, some may also ask for a board seat, further reducing the control a startup has over their company. 

In this respect, “no dilution and full control” applies only to a limited extent in the case of venture debt. 

Additionally, the interest rates are normally higher than traditional loans, ranging from 8 to 15% – sometimes even higher. Furthermore, the actual costs go far beyond mere interest, including warrants, fees, and legal costs.

Tailored and agile: Other alternative debt funding options

Recently, a new asset class has emerged, reshaping the financial landscape. There has been a growing number of providers offering a variety of alternative debt funding designed to the precise needs of startups and early-stage companies. 

Those providers strongly focus on technology and utilize data-driven approaches that allow growth predictions – even for early-stage companies. Their risk assessment focuses on financial metrics, recurring revenue streams, and unit economics. Capital needs are designed particularly for the business development of the startup. For example, re:cap provides this kind of alternative debt funding. 

For providers, a clear path toward profitability is considered crucial. Based on these assessments loans extending up to five years are possible. 

The use cases for alternative debt funding are very individual:

  • Building a bridge towards profitability by improving the cash flow towards break even
  • Creating a cash buffer that extends a startups runway, securing additional months until the next equity round and therefore gaining more time to improve financial KPIs
  • Covering large one-time expenses (events, hardware, or M&A), allowing companies to preserve cash balance and financial stability

Alternative debt funding designed to fit a company’s needs

There are also several advantages of alternative debt funding: companies can get the cash balance they want, it is non-dilutive, offers flexible terms, allows for adaptable usage, and does not involve warrants.

Central with this type of debt funding is the focus on the actual capital needs of a company. Usually, a term loan comes with a large funding amount transferred all at once – which seems positive at first sight. But companies need to deploy the capital efficiently in a rather short period. Otherwise, it just causes interest. Therefore, large one-time funding amounts have no seat in alternative debt funding, as they tend to cause unnecessary capital costs and undermine capital efficiency.

The prevailing goal is to avoid overfunding and ensure that startups actively deploy their funding rather than letting it sit idle in their bank account, where its potential remains untapped.

Keeping up to date with alternative funding options

To properly utilize debt funding, it is important to remain well-informed about the latest options available. Founders and CFOs should recognize the importance of creating a diverse capital structure with various funding sources, enabling the utilization of different types of capital for specific investments. 

It is vital for startups to thoroughly assess and select the appropriate options based on their specific use cases. Additionally, companies should integrate alternative debt funding into a well-rounded capital stack that considers traditional financing avenues such as venture capital and bank loans, ensuring a comprehensive approach to funding.

Want to take control of your funding? re:cap offers alternative debt funding. You get optimal funding amounts, timing, and usage – tailored to your needs. So you avoid overfunding, as every cent comes with costs that impact your cash balance.