Debt financing is helpful for many reasons. That’s why many startups use it to pay for expenses, purchase assets, and afford expansions. Meanwhile, startup companies must meet specific qualifications based on a lender’s criteria. Then they agree to the payment terms, loan length, and interest rate. But debt financing requires alternative collateral to equity financing. And it’s essential to know the difference.
With debt financing, the business owners give up a portion of their company in exchange for funding. And as risky as that sounds, it often benefits the entrepreneur. So, should you consider financing the debt in your venture? Or is there a better way to get the money you need?
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The type of loan determines how debt financing works. So, here are the three primary forms of business funding:
Business term loans get paid upfront in a lump sum. They usually come with a fixed repayment date and a predetermined interest rate. This type of funding may either be secured or unsecured by collateral.
A line of credit is also known as a revolving loan. That means you can reuse the credit line once you pay off existing debts. Therefore, you only repay the funds required for your objectives.
Cash flow loans give you capital based on your current cash flow. So, the lender deducts the monies owed and gives you the remainder. In many cases, this is also called “invoice financing.”
Debt financing examples are more common than you think. Most people finance debts to pay for everyday expenses and financial emergencies. These are some examples:
- Loans from family
- Bank loans
- Personal loans
- Lines of credit
- Government-backed loans
- Credit cards
- Equipment loans
- Real estate loans
Each funding type provides different rights and demands exclusive responsibilities. Plus, some are short-term while others are long-term. Always consult a financial advisor for more information.
Short-term debt financing refers to loans with one year or less repayment period. Borrowers have twelve months to return the money in full before asking for more. On the other hand, long-term loans have a repayment period of more than one year. So, borrowers get more time to pay it back.
In most cases, startups secure short-term loans to fund their day-to-day activities. They might also use the cash for emergencies. However, long-term financing is best for megaprojects, such as purchasing premises or updating equipment.
Sources of debt financing are plenty. You get several choices when securing the capital for your company. But every opportunity involves risk. So, study the pros and cons carefully. Here is where to begin:
- Credit unions
- Family and Friends
- Online Lenders
- Non-Profit Lenders
- Merchant Cash Advance Companies
Other options might become available based on your creditworthiness and time in the industry. Let’s look closer at the most popular debt financing alternatives:
SBA is an organization under the federal government. It looks out for the welfare of small businesses, ensuring they have access to affordable funding. The SBA does not provide loans to startups, though. Instead, the entity secures small businesses’ access to loans by acting as the guarantor for those loans.
Startups aren’t wholly excluded, however. Three SBA programs can help new companies secure funding:
- 7(a) Program – Arguably the most common offering by SBA, startups can receive up to $5 million in funding.
- Microloan Program – This tailor-made opp for startups provides between $500 to $50,000 in liquid capital
- CDC/504 Program – Suitable for businesses looking to engage in capital-intensive undertakings, companies can access up to $5 million with a flexible repayment plan of up to 20 years.
These are the traditional loans that banks and credit unions offer. Lenders provide money and charge a certain percentage of interest within a fixed repayment period. The unwavering terms make it easier to predict how much the total loan will cost you.
A business line of credit offers the most funding flexibility. It gives you the option to obtain funding for everyday business expenses. You can access another loan once you’re done servicing your existing debt. And the spending conditions are few compared to other debt financing opportunities. Plus, you only pay interest on the monies borrowed.
Equipment financing is one of the most accessible loans because many lenders don’t require a down payment. Instead, the equipment you purchase acts as collateral. And if you’re unable to service your loan as agreed for any reason, they will auction the equipment to get back what you owe.
Invoice financing works when clients make regular late payments. The lender recovers a percentage of what you owe every time a client pays the invoice. And the terms continue until the debt is paid in full. In most cases, lenders provide around 80% of your invoices.
Merchant cash advance services have gained traction over the years. An MCS offers easy business debt financing. In exchange, the loan is repaid in total plus additional deductions, which are made from the businesses’ daily credit and debit card sales.
Most merchant cash advance services will process your loan in a couple of hours. On the downside, the daily debit and credit card deductions could eat into your cash flows, affecting your business’s overall financial health. Moreover, it could cost you an arm and a leg to service your loan.
The finance industry has grown in leaps and bounds thanks to technological advancement. There has been the emergence of new types of debt financing alongside traditional debt financing. The primary beneficiary is the borrower. Some of the most common forms of debt financing are:
- Bonds are publicly or privately listed firms. They are used to source funds by allowing public members to purchase debt securities and earn interest at a fixed rate.
- Debentures work the same way as bonds, but the issuing parties do not put up collateral. Instead, they depend on their excellent reputation.
- Mortgages are used to purchase assets and property. But the amount of mortgage you qualify for depends on the property’s value. So, the repayment plan is usually spread over many years.
- Recovering Revenue Lending is popular with businesses in the SaaS industry or those with recurring revenue. For example, it works best for those with a subscription method of operation. The loan is issued based on a percentage of the company’s monthly earnings.
Acquiring a debt financing startup is more complicated than accepting the first offer you find. So, here are a few factors that are worth considering:
- Long-term goals
- Prevailing interest rates
- Need for control
- Borrowing requirements set by the lender
- Business structure
- Future repayment plans
With debt financing, you take control of your business. Unlike equity financing, which requires a stake in your business, financed debt lets you retain full ownership of your company. Therefore, the lender only provides the money. They don’t get a say in how you run things.
You also get numerous tax benefits. Most interest rates from debt financing are tax-deductible, regardless of the industry. Meanwhile, you can write off origination fees and enjoy a myriad of other tax benefits. And with debt financing options easier to procure than different types of loans, the possibilities are endless.
For example, compare debt financing to its counterpart – equity financing. You’ll see that there are far fewer requirements when you finance debt. Handing over a stake in your company can be risky, and the legal conditions might overwhelm your staff. With several opportunities to consider, it’s crucial to weigh the pros and cons.
Restrictive lending practices from traditional banks no longer bind seasoned business owners and entrepreneurs. Today, startups can sift through a pile of debt financing options to find one suitable for their goals. Moreover, financing business debts can help improve your credit, especially if you repay the loans in full and on time.
DID YOU KNOW: Frugal repayments can help lower your interest rate on future funds.
Debt financing is not without risk. You could lose your business or personal assets if you’re not careful. That’s because financed debt is a secured loan. So, you must provide some type of collateral for approval. But fail to pay back the money as agreed, and the lender can repossess the assets.
At the same time, this funding technique can decrease your available cash flow. That’s because it involves making regular payments despite your business’s equity. If you procure a loan with a variable interest rate, you could pay even more. Add in the effects of inflation, and resources can become scarce quickly.
You might not even qualify for debt financing options. Although qualifying is easier than equity financing, some entrepreneurs can still run into trouble. The rigorous screening process alone is enough to deter many businesses. And new companies may fail to meet the criteria if their personal credit history is too recent or their scores are too low.
With so many options available, some businesses may have difficulty figuring out which one to choose. So, always weigh the pros and cons first. Then, examine your budget to determine what you can afford. Remember, debt financing still requires regular payments. So, you shouldn’t spend money you can’t repay.
Check these boxes for choosing the best debt financing option for your business:
- Nature of Your Industry
- Amount Required
- Purpose of Funds
- Ability to Repay
The amount of money you require depends on your current cash flow, not on business projections. Also, consider the creditworthiness of your company. If your scores are low, your interest rates will be high. And remember that startups usually qualify for less funding than established companies. Try to be realistic and let your business grow organically.
Next, use the funds wisely. Make the money work for you instead of against you. That means streamlining your daily expenses and purchasing durable equipment with comprehensive insurance.
The nature of your business is crucial as well. Let’s say you run a seasonal shop, for example. You’ll most likely fall short on funds during the off-season but have plenty to spare otherwise. In those cases, you might not qualify for debt financing above a specific cap. Or the lenders might assume you’re too much of a risk because of market volatility.
Debt financing is a wise option if you can guarantee on-time payments for the loan duration. Most lenders won’t risk their investment in failing companies that struggle to make ends meet. So, you have to demonstrate industry relevance and fiscal responsibility to qualify. Plus, the more you borrow, the higher your payments will be.
Fortunately, you don’t have to choose debt financing if it doesn’t work. There are several other options for small businesses, startup companies, and large corporations. The key is to familiarize yourself with the different offerings and learn about their requirements. Then, protect your venture with smart cash flow decisions that help your business thrive.
About the Author
Jonathan Hung is one of the most active angel investors in Southern California; his mission is to drive value creation within each portfolio company. In support of this mission, he serves as Co-Managing Partner at – Unicorn Venture Partners.
He and his team target investments in US companies that have global market potential, focusing on long-term growth expansion to East Asian markets.
As a Managing Member for his family office fund, J Heart Ventures, Jonathan developed his investing prowess, which made investments in start-up companies such as Gyft, ChowNow, Miso Robotics, Clover Health, and Bitmain, to name a few startups he funded.
Jonathan has various degrees from the University of Southern California, London School of Economics, Massachusetts Institute of Technology, and The Wharton School at the University of Pennsylvania.