How Much Debt is too much Debt?

Hi! I'm Jason, and welcome back to INTRO to Finance – your guide to the financial peaks and valleys of startup finance. This week's question is one of the best and one of the hardest we’ve received:

"How much debt is too much debt?"

All too often, startups try to raise debt and equity in the same way by asking for a significant amount to last them for an extended period. However, the differences in financing require a different approach. Today we're going to offer a simple framework to consider for your own business.

Don’t Try to Do Too Much

For some time, founders have raised equity funding based on a feast/famine cycle every 12-24 months.

However, raising two years of debt financing can get you into trouble. Instead of thinking in large lump sums of capital, think in smaller financing amounts growing over time. Debt providers can put more money into the business at shorter intervals.

You shouldn't expect to raise more debt financing than your business's annual revenue. The debt payments would likely be too much for the company to support. The only situation where it makes sense to have debt exceed your yearly revenue is to have assets to support the financing.

Another way to gauge if the debt is too much is by looking at the monthly payments you're required to make. Like we said in a previous post, the monthly amount of debt payments should not exceed ⅓ of your burn. If your "debt to burn" ratio is out of whack, it will likely scare away new investors for fear that their funding will be primarily used to pay off your debts.

For companies transitioning to profitability or are already profitable, you should be striving to keep your monthly debt payments lower than 50% of your monthly profit. Keeping debt payments as a small percentage of profits allows you to pay back the debt more easily.

If you think the amount of debt financing offered to you might be too small to move the needle for your business, it may be time to rethink. We've said it before, and we'll repeat it here: debt financing scales differently from equity funding. 

Instead of trying to find one large debt product to solve all of your financing needs, address each need with a specific solution. Having purpose-driven funding will have a more substantial impact on your business than force-fitting a jumbo loan into every need. Use distinct products to match the unique timelines and amounts of each funding need.

The beauty of using a mix of financing to scale is there are complementary financial products for every part of your growing business. As you meet your milestones and prove a profitable partnership, you'll have debt providers begging to give you more money. Not to mention a lower Cost of Capital.

If you’re not quite sure where to start, we have a suggestion – create your INTRO profile. We’ve taken all the guesswork out of which financial products are available to fund various parts of your business. Our non-dilutive financing partners are standing by.

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