When you are seeking to raise capital for your company, you will likely turn to either debt financing or equity financing. For companies that do not want to give up ownership in exchange for funding, debt financing may be your best option. There are a variety of different sources for debt financing, each with its own advantages and disadvantages. In this article, we explain how debt financing works and how to secure it.
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What is debt financing?
Debt financing is the process of borrowing money to fund the growth or operations of a business.
The borrowed money must be repaid to the lender over time with interest. Unlike equity financing, the company will not have to give up any ownership to raise money with debt financing.
How does debt financing work?
With debt financing, companies sell debt instruments such as bonds, bills, or notes in exchange for a loan. The lender, which is either an individual or an institution, is promised repayment of the principal and the agreed-upon interest at a future date. The company that borrows the money typically pays back the principal and interest over time in regular installments.
The cost of debt financing is the interest rate, which is primarily determined by the company’s creditworthiness and market rates. Companies with lower creditworthiness—determined by a number of factors—should expect higher interest rates for loans.
Sources of Debt Financing
There are a variety of people and institutions from which your company could obtain debt financing. We’ve listed some of the most common sources of funding below:
Friends and Family
Your friends and family may be willing to lend you money, providing a much easier route to securing capital than through traditional bank loans or other financial institutions. Friends and family loans may be informal loans and can even have favorable terms; however, these loans are not without risk, as oftentimes personal relationships may be put in jeopardy.
A credit card, whether personal or business, can be useful to have for many immediate and short-term financial needs when used responsibly. Many credit cards offer instant approval, low introductory rates, cashback benefits, and other perks. It’s important to remember, though, that after any promotional periods, many cards have extremely high interest rates.
- Term loans. Business term loans typically come in short, medium, or long-term forms. Long-term or medium-term loans are generally offered by banks and credit unions, while many short-term loans can be secured from online lenders. Traditional bank loans typically have the lowest interest rates on the market but more stringent eligibility requirements. Short-term loans from online lenders generally have much higher rates but are easier to qualify for.
- SBA loans. Some of the best loans for small businesses are backed by the Small Business Administration. These loans offer low interest rates and attractive repayment terms for small businesses that qualify. SBA loans are partially guaranteed by the government, allowing commercial lenders to limit their risk.
- Personal loans. You can use your own credit history to obtain a personal loan but use it to finance your business. There are many traditional institutions and online lenders that offer personal loans.
- Lines of credit. This is a type of loan that’s similar to a credit card. You can access the line of credit at any time for any business need that arises. You’ll only repay or pay interest on the funds that you take out. Like a credit card, you will refill your “credit line” when you repay what you take out so you can continue borrowing from the business line of credit.
- Equipment financing. This is a type of loan taken out to purchase equipment in which the equipment acts as the collateral for the loan. Should you stop repaying the loan, the lender can repossess the equipment.
- Invoice financing. You can borrow money against your incoming invoices. Lenders will typically give you a cash advance of up to 85% based on the value of your unpaid invoices. You will repay the lender when your invoices are paid.
- Merchant cash advance. For this type of loan, the lender takes a small percentage of your company’s credit card sales until you can pay back the loan in full.
Advantages of Debt Financing
There are various reasons why a company might decide to raise money through debt financing instead of equity financing or an alternative source of funding.
- You don’t give up ownership. Debt financing doesn’t require you to exchange ownership of your company to raise money. With equity financing, you’ll be losing some control and autonomy of your company. Equity investors will want a say in the decision-making process, potentially a share of the future profits, and possibly a seat on the board. With debt financing, the lender doesn’t have any say in the decisions of the company and the relationship between the company and the lender ends once the loan has been repaid.
- Tax deductions. Interest payments on your debt is deductible as a business expense.
- Predictability. The monthly payment is usually a set amount that can be budgeted for over a long period of time.
- Builds up business credit. Making payments on your loan on time can help you improve your business credit.
- Flexibility. There are many traditional bank lenders and online lenders to choose from, each with their own terms, interest rates, and requirements. You can shop around to choose the best institution to borrow from.
- Easier access. Qualifying for a loan is often simpler and easier than obtaining investment capital or a small business grant.
- Standardized application process. Unlike equity financing, in which business owners are vetted by investors through a variety of means, debt financing applications are a fairly standardized process coordinated by banks, lenders, and credit reporting agencies.
Disadvantages of Debt Financing
- It must be repaid. Equity financing does not have to be repaid. If the business must be liquidated, lenders have a higher claim than equity investors who are the last to receive any money.
- There’s interest. The cost of taking out a loan is the interest paid—you are paying back more than just the amount you borrowed.
- High interest rates. Depending on the lender and your business credit, you may face high interest rates. It’s not unusual to see interest rates of 30% or higher with some types of loans.
- Repayment is required no matter what happens. The monthly payments must be paid even in times when your business is suffering a downturn or cash flow problems. Businesses may not have consistent revenue, so the fixed repayments can become an issue during slower times. You may damage your credit history if you do not meet the obligations.
- You may need collateral. You often need collateral for long-term loans. If the business owner puts up some of his personal property as collateral, those assets may be seized if he does not repay the loan on time.
Debt Financing vs. Equity Financing
Equity financing is the process of selling ownership of your company in order to raise funds. Unlike debt financing, the money doesn’t have to be repaid. However, investors may be expecting a high rate of return. Investment capital can be raised from a variety of sources including friends and family, angel investors, venture capital, and initial public offerings.
It may be easier to obtain a loan than to attract investors. While obtaining a loan usually involves a standard application process, equity financing will involve an intense vetting process in which only companies with the most promising business models, teams, and markets receive funding. Your company will be evaluated by angel investors and venture capital firms that may have significant experience in your industry.
With equity financing, you will lose some control and autonomy to your investors. On one hand, angel investors and venture capital investors will be able to help your company with mentorship and connections. However, the investors will have a say in the decision-making of your company and may want a seat on the board. The lenders who fund your company through debt financing will not be involved with your company except when dealing with the loan itself.
Equity financing can also be more flexible than debt financing because there is no monthly repayment schedule. Businesses that don’t have consistent revenue may find it challenging to make loan payments during slower periods or downturns. However, debt financing does offer some predictability as the monthly payments can be planned for over a long period of time.
Equity financing is often sought out by startups that have high growth goals—their business models and teams will be scrutinized by angel investors and venture capitalists who are seeking a high rate of return for their investment over a period of a few years. Debt financing is often appropriate for small businesses in traditional industries with some track record of profitability and expectations of enough revenue to repay the loans.
Debt financing is one of the primary ways that companies raise money to fund their growth or operations. From traditional bank loans to SBA loans to credit cards and lines of credit, there are a variety of sources of funding that may fit your specific needs. Unlike equity financing, companies will have to repay the loan over a specific period of time—with interest. However, debt financing can be attractive to small businesses because it can be easier to obtain and doesn’t require giving up ownership of the company.