Debt financing is a strategy that involves borrowing money from a lender or investor with the understanding that the full amount will be repaid in the future, usually with interest. In contrast, equity financing—in which investors receive partial ownership in the company in exchange for their funds—does not have to be repaid. In most cases, debt financing does not include any provision for ownership of the company (although some types of debt are convertible to stock). Instead, small businesses that employ debt financing accept a direct obligation to repay the funds within a certain period of time. The interest rate charged on the borrowed funds reflects the level of risk that the lender undertakes by providing the money. For example, a lender might charge a startup company a higher interest rate than it would a company that had shown a profit for several years. Since lenders are paid off before owners in the event of business liquidation, debt financing entails less risk than equity financing and thus usually commands a lower return.
Though there are several possible methods of debt financing available to small businesses—including private placement of bonds, convertible debentures, industrial development bonds, and leveraged buyouts—by far the most common type of debt financing is a regular loan. Loans can be classified as long-term (with a maturity longer than one year), short-term (with a maturity shorter than two years), or a credit line (for more immediate borrowing needs). They can be endorsed by co-signers, guaranteed by the government, or secured by collateral—such as real estate, accounts receivable, inventory, savings, life insurance, stocks and bonds, or the item purchased with the loan.
When evaluating a small business for a loan, Jennifer Lindsey wrote in her book The Entrepreneur's Guide to Capital, lenders ideally like to see a two-year operating history, a stable management group, a desirable niche in the industry, a growth in market share, a strong cash flow, and an ability to obtain short-term financing from other sources as a supplement to the loan. Most lenders will require a small business owner to prepare a loan proposal or complete a loan application. The lender will then evaluate the request by considering a variety of factors. For example, the lender will examine the small business's credit rating and look for evidence of its ability to repay the loan, in the form of past earnings or income projections. The lender will also inquire into the amount of equity in the business, as well as whether management has sufficient experience and competence to run the business effectively. Finally, the lender will try to ascertain whether the small business can provide a reasonable amount of collateral to secure the loan.
ADVANTAGES AND DISADVANTAGES OF DEBT FINANCING
Experts indicate that debt financing can be a useful strategy, particularly for companies with good credit and a stable history of revenues, earnings, and cash flow. But small business owners should think carefully before committing to debt financing in order to avoid cash flow problems and reduced flexibility. In general, a combination of debt financing and equity financing is considered most desirable for small businesses. In the Small Business Administration publication Financing for the Small Business, Brian Hamilton listed several factors entrepreneurs should consider when choosing between debt and equity financing. First, the entrepreneur must consider how much ownership and control he or she is willing to give up, not only at present but also in future financing rounds. Second, the entrepreneur should decide how leveraged the company can comfortably be, or its optimal ratio of debt to equity. Third, the entrepreneur should determine what types of financing are available to the company, given its stage of development and capital needs, and compare the requirements of the different types. Finally, as a practical consideration, the entrepreneur should ascertain whether or not the company is in a position to make set monthly payments on a loan.
No matter what type of financing is chosen, careful planning is necessary to secure it. The entrepreneur should assess the business's financial needs, and then estimate what percentage of the total funds must be obtained from outside sources. A formal business plan, complete with cash flow projections, is an important tool in both planning for and obtaining financing. Lindsey noted that small businesses should choose debt financing when federal interest rates are low, they have a good credit history or property to use as collateral, and they expect future growth in earnings as well as in the overall industry.
Like other types of financing available to small businesses, debt financing has both advantages and disadvantages. The primary advantage of debt financing is that it allows the founders to retain ownership and control of the company. In contrast to equity financing, the entrepreneurs are able to make key strategic decisions and also to keep and reinvest more company profits. Another advantage of debt financing is that it provides small business owners with a greater degree of financial freedom than equity financing. Debt obligations are limited to the loan repayment period, after which the lender has no further claim on the business, whereas equity investors' claim does not end until their stock is sold. Furthermore, a debt that is paid on time can enhance a small business's credit rating and make it easier to obtain various types of financing in the future. Debt financing is also easy to administer, as it generally lacks the complex reporting requirements that accompany some forms of equity financing. Finally, debt financing tends to be less expensive for small businesses over the long term, though more expensive over the short term, than equity financing.
The main disadvantage of debt financing is that it requires a small business to make regular monthly payments of principal and interest. Very young companies often experience shortages in cash flow that may make such regular payments difficult. Most lenders provide severe penalties for late or missed payments, which may include charging late fees, taking possession of collateral, or calling the loan due early. Failure to make payments on a loan, even temporarily, can adversely affect a small business's credit rating and its ability to obtain future financing. Another disadvantage associated with debt financing is that its availability is often limited to established businesses. Since lenders primarily seek security for their funds, it can be difficult for unproven businesses to obtain loans. Finally, the amount of money small businesses may be able to obtain via debt financing is likely to be limited, so they may need to use other sources of financing as well.
SOURCES OF DEBT FINANCING
Small businesses can obtain debt financing from a number of different sources. These sources can be broken down into two general categories, private and public sources. Private sources of debt financing, according to W. Keith Schilit in The Entrepreneur's Guide to Preparing a Winning Business Plan and Raising Venture Capital, include friends and relatives, banks, credit unions, consumer finance companies, commercial finance companies, trade credit, insurance companies, factor companies, and leasing companies. Public sources of debt financing include a number of loan programs provided by the state and federal governments to support small businesses.
PRIVATE SOURCES Many entrepreneurs begin their enterprises by borrowing money from friends and relatives. The main advantage of this type of arrangement is that friends and relatives are likely to provide more flexible terms of repayment than banks or other lenders. In addition, these investors may be more willing to invest in an unproven business idea, based upon their personal knowledge and relationship with the entrepreneur, than other lenders. A related disadvantage, however, is that friends and relatives who loan money to help establish a small business may try to become involved in its management. Experts recommend that small business owners create a formal agreement with such investors to help avoid future misunderstandings.
Banks are the sources that most people immediately think of for debt financing. There are many different types of banks, although in general they exist to accept deposits and make loans. Most banks tend to be fairly risk averse and proceed cautiously when making loans. As a result, it may be difficult for a young business to obtain this sort of financing. Commercial banks usually have more experience in making business loans than do regular savings banks. It may be helpful to review the differences among banks before choosing one as the target of a loan request. Credit unions are another common source of business loans. Since these financial institutions are intended to aid the members of a group—such as employees of a company or members of a labor union—they often provide funds more readily and under more favorable terms than banks. However, the amount of money that may be borrowed through a credit union is usually not as large.
Finance companies are another option for small business loans. Although they generally charge higher interest rates than banks and credit unions, they also are able to approve more requests for loans. Most loans obtained through finance companies are secured by a specific asset as collateral, and that asset can be seized if the entrepreneur defaults on the loan. Consumer finance companies make small loans against personal assets and provide an option for individuals with poor credit ratings. Commercial finance companies provide small businesses with loans for inventory and equipment purchases and are a good resource for manufacturing enterprises. insurance companies often make commercial loans as a way of reinvesting their income. They usually provide payment terms and interest rates comparable to a commercial bank, but require a business to have more assets available as collateral.
Trade credit is another common form of debt financing. Whenever a supplier allows a small business to delay payment on the products or services it purchases, the small business has obtained trade credit from that supplier. Trade credit is readily available to most small businesses, if not immediately then certainly after a few orders. But the payment terms may differ between suppliers, so it may be helpful to compare or negotiate for the best terms. A small business's customers may also be interested in offering a form of trade credit—for example, by paying in advance for delivery of products they will need on a future date—in order to establish a good relationship with a new supplier.
Factor companies help small businesses to free up cash on a timely basis by purchasing their accounts receivable. Rather than waiting for customers to pay invoices, the small business can receive payment for sales immediately. Factor companies can either provide recourse financing, in which the small business is ultimately responsible if its customers do not pay, and nonrecourse financing, in which the factor company bears that risk. Although factor companies can be a useful source of funds for existing businesses, they are not an option for startups that do not have accounts receivable. Leasing companies can also help small businesses to free up cash by renting various types of equipment instead of making large capital expenditures to purchase it. Equipment leases usually involve only a small monthly payment, plus they may enable a small business to upgrade its equipment quickly and easily.
Entrepreneurs and owners of startup businesses often must resort to personal debt in order to fund their enterprises. Some entrepreneurs choose to arrange their initial investment in the business as a loan, with a specific repayment period and interest rate. The entrepreneur then uses the proceeds of the business to repay himself or herself over time. Other small business owners borrow the cash value of their personal life insurance policies to provide funds for their business. These funds are usually available at a relatively low interest rate. Still other entrepreneurs borrow money against the equity in their personal residences to cover business expenses. Mortgage loans can be risky, since the home is used as collateral, but they are a common source of funds for small business owners. Finally, some fledgling business people use personal credit cards as a source of business financing. Credit card companies charge high interest rates, which increases the risk of piling up additional debt, but they can make cash available quickly.
PUBLIC SOURCES The state and federal governments sponsor a wide variety of programs that provide funding to promote the formation and growth of small businesses. Many of these programs are handled by the U.S. Small Business Administration (SBA) and involve debt financing. The SBA helps small businesses obtain funds from banks and other lenders by guaranteeing loans up to $500,000, to a maximum of 70-90 percent of the loan value, for only 2.75 percentage points above the prime lending rate. In order to qualify for an SBA guaranteed loan, an entrepreneur must first be turned down for a loan through regular channels. He or she must also demonstrate good character and a reasonable ability to run a successful business and repay a loan. SBA guaranteed loan funds can be used for business expansion or for purchases of inventory, equipment, and real estate. In addition to guaranteeing loans provided by other lenders, the SBA also offers direct loans of up to $150,000, as well as seasonal loans, handicapped assistance loans, disaster loans, and pollution control financing.
Small Business Investment Companies (SBICs) are government-backed firms that make direct loans or equity investments in small businesses. SBICs tend to be less risk-averse than banks, so funds are more likely to be available for startup companies. Another advantage is that SBICs are often able to provide technical assistance to small business borrowers. The Economic Development Commission (EDC), a branch of the U.S. Department of Commerce, makes loans to small businesses that provide jobs in economically disadvantaged regions. Small businesses hoping to qualify for EDC loans must meet a number of conditions.
Overall, debt financing can be a valuable option for small businesses that require cash to begin or expand their operations. But experts warn that carrying too much debt can cause a small business to encounter severe cash flow problems. Instead, it is best to use a combination of different forms of financing in order to spread the risk and facilitate future funding efforts. Planning is essential for entrepreneurs seeking loans and other types of debt financing. It may take time and persistence for an entrepreneur to convince a lender of the value of his or her business ideas and plans. With so many possible sources of debt financing, it is important for small business owners to find a lender with whom they can develop a comfortable working relationship. Forming a good relationship may help the entrepreneur negotiate favorable interest rates and fees, which can make a big difference in the final cost of the debt financing.