Essentially, debt is associated with a claim to assets, that are presented as “collateral” in a “secured loan” agreement. In an early stage startup that is nimble, usually it’s the intellectual property (IP) that can be considered collateral. Basically, if the borrower fails to pay its debt obligations, the lender has the right to transfer or seize the assets that collateralize the loan. Unsecured loans aren’t backed by assets and collateral, but rather by cash flow only.
Financing a venture with debt can take various forms and is very common. Entrepreneurs choose to finance with debt for various reasons, including the desire to not dilute the company’s equity and thus hold onto more for the founders and employees; to appease current shareholders for the same reason; to avoid pricing the shares of the company prematurely; to achieve tax benefits; to bridge the company’s cash flow needs until the next round of equity financing and a whole myriad of other reasons.
There are a host of different ways to finance a company through debt. One way is through simple loans. Friends and family will often “loan” money to a company, often at a 0% interest rate. The same applies to co-founders and early shareholders who may loan the company money. Some angel investors will do simple loans at low interest rates for they want to see the company get off the ground.
Other forms of debt financing include credit cards. Surprisingly, despite the high interest rates, many ventures are funded through the use of credit card debt. While the team at StudVent is not endorsing this method per se, there are strategies for doing this that can read about through some simple searching.
Often, more sophisticated debt financial arrangements take the form of convertible notes (or convertible notes, or convertible loans as they may be referred to by others). The answer to “converts into what” is equity, usually at some future point, triggered by a further financing event. In many markets, such as the USA, this is a tried and tested method of early stage financing.