Knowing the ins and outs of debt financing, and whether it's the right choice for you, could be the difference between your startup fighting an uphill battle or getting the leg-up it needs to succeed.
The alternative to debt raising is equity financing, which of course may be the road you choose. But as with any business decision, it’s important to weigh up the pros and cons first.
What is debt financing?Debt financing is any type of loan that a company uses to fund its business as part of the capital raising process. Essentially, when a business chooses to fund their working capital with a loan, it means they get their money from an outside source. This incurs a debt to the lender of those funds.
Loans can be either long or short term, based on the needs of your business. Short term debt financing often applies to day-to-day operations - such as supplies, inventory management, and wages - and are generally repaid in less than a year. The reason for choosing short term debt finance varies from business to business, but it generally helps with temporary cash flow issues, which are common for startups.
Long term vs short term
Long term debt raising on the other hand, often applies to business assets such as land, equipment or buildings. Repayment of a long term debt finance can be up to 10 years.
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Types of debt financingDebt financing can take place in several ways.
Term loansTerm loans are what most people would naturally think of when discussing business loans. They work on the basis of the traditional loan structure - that being, a business borrowing money (a certain amount for a particular purpose) and proceeding to pay this debt back over a fixed period of time at a fixed interest payment rate.
Line of creditA line of credit is possibly the most flexible type of debt raising method. This kind of loan gives a business capital, which they can draw upon in order to meet their business needs. Once a line of credit is put in place, you may draw on your line of credit as you would with personal credit cards.
Merchant cash advanceA merchant cash advance involves a lump sum payment from a lender in exchange for a percentage of the businesses sales. This type of debt financing means that the borrower will agree to pay back the cash advance, plus an additional fee by letting the lender automatically deduct an agreed percentage of daily sales.
Other examples of debt financing include:
- Bank loans or personal loans
- Family or friend loans
- Government-backed loans
- Invoice financing
- Equipment financing
Advantages and disadvantages of debt financing
|Advantages of debt raising
||Disadvantages of debt raising
How it compares with equity financing
We mentioned above, that an alternative to debt financing would be equity financing. So, what is the difference between debt financing and equity financing?
The key difference with equity financing is that funds are raised through the sale of shares in your business. Therefore rather than lending money from an outside source, you are giving ownership of company stocks in exchange for capital.
There are many advantages and disadvantages to choosing the equity financing route. Some advantages include lower risk and no outstanding debts, while disadvantages include investors gaining ownership and the need to consult with investors for all future business decisions.
Learn more: Equity Financing
Business planning: why it’s essential
The decisions we make as small business owners or entrepreneurs can open doors to numerous possibilities. When it comes to capital raising - money - these decisions are not to be made lightly. You need to consider the state of your business and your capabilities to uphold the decision you have made, be that paying back a loan or giving up some ownership of your startup.
For this reason, business planning goes hand in hand with any capital raise. Consider all the pros and cons, put a schedule together for monthly payments at the very start and discuss your future with all relevant stakeholders.
In addition to this, it’s vital to have all the relevant documentation in order. Having your paperwork organized will make capital raising a whole lot easier, quicker and more likely to be successful.