What Is Debt Crowdfunding?
Debt crowdfunding is when a company — usually a small business — agrees to accept a loan funded by multiple investors online. The company must repay the loan (plus interest) to investors over a set period of time. The minimum investment in these loans are typically small, so a company needs several investors to raise the money it needs (that’s the crowdfunding part). Debt crowdfunding can also be referred to as debt financing or a debt round. We’ll just call them debt deals to keep things easy.
You might have also heard of revenue share agreements referred to as a type of debt deals. While debt and revenue share agreements share some similar characteristics , revenue share agreements are different enough that we’ll cover them in another article.
How Do Debt Deals Work?
So a company is using the online private markets to fund a loan for itself — a debt deal. That company also gets to decide on repayment terms that determine how potential investors in the debt deal will be repaid. There are three main parts of repayment terms that investors should pay attention to:
- Interest rate – the interest rate indicates how much extra the company will pay each investor back beyond their investment amount. It’s usually represented as a percentage, and it’s kind of like the return on investment for debt deals.
- Term length – the term length indicates how long the debt will last. It’s the total time period where interest and principal is being paid back to investors.
- Payment Schedule – the payment schedule indicates how often investors will receive payments from the company. While interest will be compounded monthly, payments could be dispersed monthly or quarterly.
All of these repayment terms can be found in the offering circular for a given debt deal. They’re also usually found on a company’s raise page.
Debt Deal Example
Now that we’ve gone over the basics, let’s look at an example of a debt deal.
Dead Lizard Brewing raised money through a debt deal in order to create a marketing budget and increase consumer awareness. The terms of the debt deal were a 11.75% interest rate, five year term length, and quarterly payment schedule. So let’s pretend you invested $100 in Dead Lizard Brewing. That means that over the next five years, the business is required to pay that $100 (the principal) back to you plus interest. And it will make those payments to you every three months. At the end of five years, you should receive 20 payments that total $132.71 ($100 in principal plus $32.71 in compound interest).
How Are Debt Deals Different From Equity Investments?
There are a lot of differences between investing in debt and investing in equity in the online private markets. Let’s run through them one by one.
The biggest difference between debt and equity investments is what the investor gets out of it. With equity, you are gaining direct shares in a company with the hope that those shares will grow more valuable over time. The only time a startup investor can make profit off of their investment in the form of cash is when there’s a liquidity event (either the company gets acquired or goes public on a stock market). It can take up to 10 years (and sometimes longer) for a liquidity event to happen. And even then, there’s no guarantee. If there’s a liquidity event, you may have the option to sell some or all of your shares (cashing out on the investment) or to continue to hold them.
With debt, you are lending money to a company with the expectation that the company will pay your money back plus interest over a set time period. Five-year loan terms with quarterly payments is fairly typical. Once the loan has been repaid, you have no ongoing relationship with the company anymore. Your return on investment is known upfront and dependent on the company paying you back.
Size of Returns
Both debt and equity deals carry the same risk of the company in question failing. (Although, as we’ll explain below, debt deals may have a higher chance of recouping some of their investment in such cases.) But the risk-to-reward profile is very different between equity and debt.
When gaining equity in startups, most investors are hoping for outsized returns (meaning they will receive returns of 10x or more). Since around 90% of startups will fail, startup investors achieve outsized returns by having a diverse portfolio of many startup investments. While most of their portfolio companies may provide no returns at all, the ones that do provide returns could make up for all the others.
Debt investments are more predictable — but returns are also more limited. Because the terms of repayment are laid out from the very start, debt investors will already know what their returns will be (it’s the interest rate for the deal). And while that return will never be outsized like equity returns can be, it can be a source of passive income for the investor.
Startups vs Small Businesses
Generally speaking, the type of company that you’re investing in is different between equity and debt. Both involve small businesses in a technical sense. But equity deals usually attract companies that are looking to grow massively, potentially becoming nationwide or global in reach. We call these companies “startups” to indicate that they are young, still establishing themselves, but have large visions they want to achieve.
On the other side, debt deals often feature small independent companies that are (usually) focused on a limited geographical area. We commonly see restaurants, breweries, and coffee shops offering debt deals in order to aid them in business expansion of some kind. However, these companies aren’t necessarily looking to become major brand names or to grow nationwide.
A small — but important — distinction between equity and debt deals is where you can find them. In the online private market, various crowdfunding platforms (aka funding portals) specialize in different types of deals. While some choose to focus on certain industries, others are more concerned with the securities being offered.
There are far more platforms that specialize in equity deals than in debt investing. Some of the top equity platforms — in terms of deal volume and dollars invested — are Wefunder, StartEngine, Republic, and Netcapital. For debt, platforms like SMBX, Mainvest, and Honeycomb offer the strongest deal flow. To learn more about various debt investing platforms, check out this article.
You can also use KingsCrowd’s Companies Search tool to find both active debt and equity deals from the major platforms. KingsCrowd also rates the investment opportunities for both debt and equity deals to help investors make informed decisions.
Investing in private companies — especially startups — is inherently risky. And one of the things that makes equity investments so risky is the lack of transparency an investor has. You have no idea how the company will fare in a month, a year, or five years. And you don’t know whether you’ll actually get a return on your investment. Whenever you make an equity investment in a startup, you’re hoping that the company will grow and prosper — but that’s never guaranteed to happen. Even if you get a return, your shares will likely go through some amount of dilution (meaning the value of your shares will be lower than they were when you invested) by the time that return happens. But there’s no way to know how much dilution you’ll be looking at.
With debt deals, investors have far more transparency. The basic terms of repayment are laid out from the start, so investors know what to expect. And those terms won’t change partway through. While something major — like the company going out of business — could happen, debt deals still come with more upfront knowledge for investors.
In the worst case scenario — where a business you’ve invested in shuts down — whether your investment was in equity or debt could determine whether you see any repayment. When a company fails, debt holders are typically paid out before equity holders (Common and Preferred). There still may not be enough (or any) money to pay back debt obligations in full, but debt holders may have a better chance of recouping some of their investment in the case of a failed company.
Should You Invest in Debt Deals?
Now that you know the basics of debt deals, you may be wondering if you should invest in a debt deal. At the end of the day, every investment decision is individual to each investor. You should consider factors like your investing goals, your income, your investment thesis, how quickly you want to see returns, and your overall investment portfolio.
Generally speaking, a more diverse investment portfolio is a healthier portfolio. Adding some debt deals to your portfolio could be a good way to support local businesses while also receiving passive income.
- The terms for debt deals will be decided upfront by the company.
- The interest rate will determine how much money you receive in addition to the repayment of your investment.
- The term length will set the timeline for the company to repay you.
- The payment schedule will determine how often you receive payments.
- A debt investment means that you are lending money to a company in order to be paid back with interest.
- Debt deals are most often offered by small businesses rather than startups or high-growth companies.
- You will likely need to use the KingsCrowd company search tool or specific funding platforms to find debt deals.
- Debt deals offer far more transparency than equity deals.
- If a company goes out of business, it is required to pay back debt holders before equity holders (if it has enough capital to do so).
- Debt deals offer more limited returns than equity investments.
- Debt deals tend to generate returns more quickly than equity deals.
- Debt deals can be a source of passive income for investors.