What to Know About Debt Financing

What to Know About Debt Financing

Building a business requires capital, and unless you have enough cash in savings to bootstrap your business, you’ll need some form of financing to grow your company and achieve your goals.

Debt financing and equity financing are the two primary forms of attaining capital. If you’re considering debt financing, it’s important to know what it is, how it works and the different options that are available to you.

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What is debt financing?

In a traditional sense, debt financing involves a business selling bonds, bills or notes to individual or institutional investors in return for capital. In return, the investors become creditors to the business and can expect to receive payment based on the debt financing agreement. 

This form of debt financing is often used by large companies with a strong track record. Another form of debt financing — and one that’s more applicable to small businesses — entails a small business owner taking out a loan from a traditional or alternative business lender.

Depending on the type of loan, how you access the capital provided and the repayment terms can vary.

How debt financing works

Debt financing as a small business likely won’t involve selling bonds to investors. So instead, we’ll focus more on the less traditional method. 

With this form of debt financing, you typically start by determining your needs. For example, you may need access to ongoing working capital, cash to purchase a vehicle or other equipment or a large influx of money to do a number of things. 

Understanding what you need can help you determine which type of debt financing will work best for you. There are three primary forms of debt financing to consider:

  • Installment loans: These small business loans have a set repayment term and monthly payment. You’ll receive a lump-sum payment from the lender upfront, then pay back the debt in equal monthly installments until it’s been repaid in full. Terms loans, equipment financing and SBA loans are common installment loans.
  • Revolving loans: Instead of giving you a lump sum in the beginning, these loans give you access to a revolving line of credit that you can use, repay and repeat over and over again. Business lines of credit and credit cards are types of revolving loans.
  • Cash flow loans: Like installment loans, cash flow loans typically provide a lump-sum payment from the lender after you’re approved. But instead of requiring equal installment payments over a set period, repayment on a cash flow loan typically occurs as over time as you earn the revenue you’re using to secure the loan. Merchant cash advances and invoice financing are common forms of cash flow loans.

Once you know the type of loan that’s the best fit for your needs, take some time to compare different lenders that offer it. Shopping around gives you a better chance to compare multiple offers and to choose the one that will give you the best terms, and possibly save you the most money. 

One thing to keep in mind throughout this process is that small business lenders typically have various eligibility criteria that cover your creditworthiness, revenue, time in business and more. And in many cases, your personal credit history may be more of a focus than your business credit history. 

Traditional bank loans, for example, typically require strong personal credit history, high annual revenues and a few years in business. Online business loans and some other forms of financing, however, may have less stringent requirements.

Advantages and disadvantages of debt financing

As you consider whether debt financing is right for you, it’s important to know both the benefits and drawbacks of using it to build your business. Here’s what to consider:

Pros

Some forms are easy to qualify for: As a new business owner, you may have a hard time getting the capital you need. Unless you have a strong product or service and experience in the industry, investors likely won’t be interested.

Even some forms of debt financing may be out of reach for startups. But there are some available that you can access without having the revenue and time in business to back you up.

You don’t give up control: The other primary form of financing is equity financing, which involves investors providing capital in return for ownership in your company. With debt financing, you’ll need to pay back what you’ve borrowed with interest, but you don’t have to worry about sharing decisions with anyone else.

Options are flexible: Between the three types of business loans and various lenders, you’ll have a wide selection of options to choose from, even if you’re a new business owner. You can pick the loan type and lender that best suits your needs, and you may even have some control over the repayment terms, as long as it’s within the parameters set by the lender.

Cons

It can be expensive. Depending on your credit situation, time in business and loan type, you could have an interest rate of 30% or higher. Some loan types, including merchant cash advances, can have triple-digit interest rates. As you consider your options, make sure you can afford to repay what you owe.

You may not qualify. It is possible to get approved for debt financing even if you have bad credit. But if you’re looking for favorable terms, you may have a hard time getting what you want.

You may be personally responsible to repay. Many small business loans require what’s called a personal guarantee. This clause states that if your business can’t repay the debt, you’ll be responsible to pay it back with your personal assets. If there’s a question about the viability of your business, it may not be worth putting your personal finances at risk. 

Debt vs. equity financing

Where debt financing involves working with lenders to borrow money and pay it back with interest, equity financing entails trading capital for ownership, or equity, in your company. 

If you’re wondering which option is better for you, it’s important to note that equity financing isn’t even an option for most small business owners. According to a recent study by Fundable, less than 1% of businesses get funding from angel investors and venture capital firms. 

If you do have both options, however, take some time to consider the advantages and disadvantages of both. While debt financing requires you to repay what you’ve borrowed, the money raised through equity financing is yours to keep. 

On the flip side, taking on investors can dilute your control over the operations of your business, while a small business lender doesn’t have any say in how you build your company. 

There’s no correct choice between the two, so take some time to consider how they would impact you and your business, then pick the one that’s best suited to your needs and preferences.

Types of debt financing

There are several different ways you can use debt to finance your business, and we covered the main types above. Here we’ll break down those options into the different types of business loans you may want to consider for your company.

Traditional bank loans

These loans are typically a medium- or long-term loans that are designed to help your company’s growth. 

Bank loans are offered by various financial institutions, including banks, credit unions and other commercial lenders. What sets them apart from other terms loans that you can get from online and alternative lenders is that they typically have high eligibility standards. 

That said, traditional bank loans typically charge low interest rates. So if you qualify and need a large amount of capital, this may be your best option.

Business line of credit

A small business line of credit is a type of revolving loan, which allows you to draw capital when you need it, up to a predetermined credit limit. 

In addition to giving you the option to use, repay and reuse your available credit, you may also get a draw period where you only have to pay interest, after which you’ll start making full payments of principal and interest. 

Small business lines of credit are best for short-term financing or working capital needs. You may be able to qualify with some lenders if your business is relatively new, but interest rates can be high and repayment terms short. To qualify for better terms, you may need a stronger track record.

Business credit cards

Business credit cards are another form of revolving credit, and are available to all types of business owners. There’s typically no minimum annual revenue or time in business, and you don’t need a business credit history to get approved. Instead, approval is based on your personal credit history. 

Business credit cards can be used to manage your operating expenses by giving you a grace period between the statement and due dates. But they can charge interest rates as high as 30%, so it’s important to make it a goal to pay your balance in full each month. 

Another benefit of using a business credit card is the chance to earn rewards on your everyday expenses and get other benefits, such as an introductory 0% APR promotion, expense management tools and travel perks. 

Equipment financing

Most small businesses can qualify for equipment financing because of how they’re designed. If you’re buying a vehicle or another type of equipment for your startup, the thing you’re purchasing will be used as collateral on the loan.

If your business fails or just can’t repay the debt, the lender can take the collateral to satisfy the debt. Because there’s a verifiable asset with value in the mix and the lender isn’t relying on the success of your business or your ability to make good on a personal guarantee, there’s a lot less risk involved. 

Keep in mind, though, that this type of secured financing isn’t a sure thing for everyone. Lenders will likely still have a lot of criteria you’ll need to meet to qualify for a loan, it just won’t be largely dependent on how long you’ve been in business.

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