Debt Financing 101: How it Works, Types, Examples, Costs, Pros & Cons
We break down the nitty-gritty of debt financing, how it works, when and why you need it, and more, so you don’t have to tiptoe around it!
Initially, a startup is usually funded by its founders and cofounders. But, for most startups, once the company grows, the money inflow fails to keep up with its growth. It is when the founders make a tough decision of whether to raise funds by diluting the company's ownership via equity financing or switching to loans with debt financing.
While equity financing is not a startup liability and doesn't need any repayment, it weakens the ownership and decision-making hierarchy. This drives the founders to move to debt financing as a capital financing option that needs repayment at a specific interest rate.
We understand: for most budding entrepreneurs, debt financing can be a tricky terrain to navigate, let alone master and make it work for their business. So, we at BridgeUp bring you a quick rundown on everything you need to know about debt financing. Let’s begin!
What is Debt Financing?
Debt financing is the process of raising funds by selling debt instruments to people or corporate investors in the form of bonds or bank loans.
As a result of purchasing such instruments, the investor becomes the business's creditor and receives a promise to receive payment along with interest as per the debt financing agreement. Whereas, the company promises to repay the loan and the interest cost.
Traits of Debt Financing
It is a fixed finance i.e., the debt interest is fixed irrespective of the profit made by the organization
Interest on debt is a legit obligation of the company.
It holds the first claim on the revenue and assets, ahead of other finances.
It doesn’t give any voting right to the lender, and they cannot participate in making any company decisions.
Interest on debt financing is a tax-allowable expenditure.
Types of Debt Financing
Debt financing is segregated into various categories depending on the time between the investment and its repayment and the kind of loan granted:
Short-term loan: This loan is borrowed to meet short-term expenses and working capital costs such as rent, maintenance, administrative and operational expenses. Usually, the company's assets are kept as securities for these debts.
Bills: They mature in a year and are not included in interest payments. They are sold at a discounted price, and investors get the complete amount at maturity.
Revolving loan: It is given by financial institutions using a line of credit that companies can take, repay and repeat again and again.
Cash flow loan: These loans help the company borrow funds depending on their estimated future cash flow. Dissimilar to installment loans, startups repay these loans while earning revenue which was used to secure the loan.
Long-term loan: It is an investment that expands for over a year and is needed to work on growth, development, infrastructure, and other long-term strategies. Such loans need the startup to keep the company's assets as collateral after mentioning specific terms and conditions, known as covenants.
Notes: They are debts with a maturity of two to ten years. They pay interest regularly.
Mezzanine Financing: It is a blend of equity and debt financing. Lenders offer loans to companies with particular conditions that involve repayment in the form of equity if cash flow is not present. Simply put, the lender can convert the security into equity at a pre-decided price per share if the borrower company doesn't repay the loan in full or at the given time.
If a company requires money, it has three options to acquire financing; sell equity, go for debt or choose an in-between option. Equity means owning a stake in a company. It gives the shareholder a right to claim on upcoming earnings, but it doesn't have to be paid back. In case of bankruptcy, equity holders are the last to get money.
Companies go for debt financing, which involves selling fixed-income items like notes, bonds and bills to financial institutes or investors to acquire the much-needed funds to expand their working and operations. So, if a company issues bonds, those purchasing those bonds are lenders offering the company debt financing.
The loan amount is the principal, which should be paid on the given date. And, in case of bankruptcy, the lender enjoys a more significant claim on the liquidated assets compared to shareholders.
Debt financing is a preferred option for businesses. Usually, borrowers choose debts for various reasons. Here are some significant considerations involving debt financing:
Cost of Debt
The capital of a company includes debt and equity. The cost of equity involves paying the dividend to the shareholders, and the cost of debt consists in paying interest to bond owners.
So, if a business issues debt, it doesn't just ensure to repay the principal but also commits to compensate its bondholders for repaying the principal amount along with interest payments annually. The interest paid represents the borrowing cost to the issuer.
The total of cost of debt financing and equity financing is the cost of capital of a company. It represents the lowest return a company should earn on its capital to satiate its creditors and shareholders. A company's investment decisions with regard to its operations and projects should produce more returns compared to the cost of capital. If the capital's return on its expenditure is below its capital cost, the firm is not gaining any positive revenue for its investors. And it should re-assess its capital structure.
Basically, the cost of debt is the interest charged by the financial institution on the loan. The index for setting interest is the interbank rate of interest. Here credit score, leverage, loan type, and collateral work as significant factors of debt cost.
Financing approval majorly relies on the creditworthiness of the company. A borrower with collateral backing is approved quicker than an unsecured loan.
Debt Financing vs. Interest Rates
Often investors in debt financing only want to protect their principal, while others desire a return in the form of a return. The market rates and the borrower's credit score decide the interest rate. If the interest rate is high, it implies a bigger chance of default and thus carries a greater risk. High rates of interest help to compensate the borrower for the greater risk. Apart from paying interest, debt financing needs the borrower to follow specific rules about fiscal performance, also known as covenants.
Debt financing is complex to acquire. But, for many companies, it offers funding at reasonable rates compared to equity financing, especially in times of historically low-interest rates. The next benefit of debt financing is that the interest on debt comes under the tax-deductible slab. But, of course, a lot of debt can add to the cost of capital, which might lower the company's present value.
Debt Financing vs. Equity Financing
The significant difference between debt and equity financing is that equity financing offers additional working capital with zero repayment compulsion. Debt financing, on the other hand, demands repayment; on the plus side, the company doesn't have to give its ownership to someone to get funds.
Most companies go for a mix of debt and equity financing. Companies choose one or both, depending on the readily available funding type, the condition of their cash flow, and the significance of maintaining ownership control.
The founder can calculate how much financing is acquired via debt vs equity using the D/E ratio. Creditors find a low D/E ratio favorable as it benefits the company if it wants to access more debt financing in the coming time.
Advantages and Disadvantages of Debt Financing
Here are some of the advantages of debt financing:
Helps in building business credit
Making on-time debt financing payments helps establish better credit. Developing a good credit history allows companies to qualify for further loans with competitive interest rates and repayment tenure in the upcoming time.
More straightforward to plan for the future
Debt financing gives easy and quick capital access that helps with better business growth and expansion opportunities. Also, it is simpler to budget and plan for your company's future when you know how much you need to repay every month.
Tax-deductible interest payment
Usually, the interest payout on debt financing is tax-deductible. The interest tax deduction is accessible when you borrow from a lender for your business.
Keep business in control
Debt financing helps keep the business in total control, unlike equity financing. While an investor gets an equity stake in your business, a lender doesn't play any part in managing or running your business.
Disadvantages of Debt Financing
Here are some of the disadvantages of debt financing:
Risks credit history or assets
Debts are risky for your company and personal finances. To get finances, founders often have to put their business assets as collateral. And in case of default, the lender has all the right to seize those assets. Missed or late payments can also leave a negative effect on your credit rating, making it tougher to qualify for financing in the upcoming time.
Causes a fiscal strain on the business
Debt makes it tough to manage business finances. Hence, it is essential to make regular payments on your loan, irrespective of the revenue, which can be harsh on seasonal businesses (some examples include ski resorts, boating companies, or seasonal products manufacturing companies) and the ones with poor cash flow. Often debt financing makes it challenging for the company to grow its operations.
How to choose Debt Financing for your Business?
If you’re planning to finance your business with debt, it is vital to keep these factors in mind to choose the suitable options according to your needs:
Why do you require the funds?
How much funding do you need?
What is the qualification of your business? (It includes your credit score, the time for which the company has been running, and its yearly revenue)
How fast do you need the funds?
What amount of debt can you bear?
Debt Financing FAQs
Mention some examples of debt financing.
Some prominent examples of debt financing are loans from friends and family, bank loans, government loans like SBA, credit cards, LoC, mortgages, and machinery or equipment loans.
What are the different kinds of debt financing?
Debt financing is available in different options, such as installment loans, cash flow loans, and revolving loans.
Installment loans feature repayment terms and monthly payouts. The borrower gets the funds as a lump sum amount. They can be secured or unsecured loans.
Revolving loans offer easy access to a continuous line of credit that a borrower can use, repay and repeat, such as credit cards.
Cash flow loans offer a full-fledged amount to the borrower. Once the borrower starts making money, they can make the payment. Some examples are merchant cash advances and invoice financing.
Can debt financing be categorized as a loan?
Yes, the loan is a common type of debt financing.
Should you go for debt financing?
Debt financing can be both good and bad. When a business uses debt to stimulate growth, it is good. But, the company should ensure it meets its obligations regarding payments.
How to raise debt funding?
The position of raising debt funding is just the start. Next, the person should conduct a deep market survey to make a proper list of investors or firms which are into startup debt financing and enjoy a good track record and experience. Startups can turn to investors who provide debt funds and venture capitalists that offer business debt financing deals to balance profit and loss and enhance their investment portfolio. Meanwhile, businesses can get debt funding from banks, MFIs, and NBFCs.
To choose the right investor along with a reasonable interest rate, the companies should do a proper background check concerning their history, credibility, and terms and regulations. The job that’s left is persuading the investors, for which the entrepreneur/founder should present a robust business pitch with a transparent plan and strategies, balance sheets of the company, and a specific path of development proven via documents and data.
On the same note, investors should check all the documents and verify the claims and credibility of the startup backed by due diligence.
Why is debt financing critical at times?
In India, the startup revolution is fairly recent. So, the complete background checking and documentation are rigidly maintained by banks, non-banking monetary companies, and microfinance units. With the startup ecosystem just a few years old, investors are skeptical about investing in such businesses and most often refuse. Banks, big businesses, and NBFCs showcase poor confidence in startups and often reject funding appeals. Thus, it is pretty difficult for companies to get proper funding, and the same goes for equity funding.
To resolve the issue, the Government of India has entered the picture to motivate the youth to dive into entrepreneurship and develop a robust and broad ecosystem for such growing businesses in the country. Under the Pradhan Mantri Mudra Yojana, the Government now offers several easy loans to new and growing companies at reasonable rates of interest and terms and conditions. The loans are provided through banks and NBFCs, once the business plan is furnished along with the necessary documents.
After the sanctioned sum is disbursed, banks and NBFCs are refinanced by the government-approved NBFC, Mudra. Often microfinance companies also provide microcredit schemes to render debt funds to businesses. So, loans and microcredit schemes offer debt funds to businesses to promote entrepreneurship with simple terms and conditions and easy interest rates.
There are several private companies, investment organizations, and business networks that support entrepreneurs by providing debt financing in every way. They also offer technical assistance, infrastructural help, and business strategies to render help to first-time businessmen so that they grow and upscale their businesses. Thus, it’s evident that debt funding is playing a major role in the government’s strategy to uplift new businessmen and the economy via a robust startup ecosystem.
Conventional equity financing is tough to maintain, majorly for small and new startups. Venture capitalists usually look for businesses with an international reach. Angel investors who fund on a minimal scale also look ahead to invest around $600,000 in new companies, but most angel investors also invest less.
So, if you are a startup owner looking to serve a local market and don’t need big-scale funding, debt financing is the best and only alternative. Usually, prominent startups often team debt and equity financing to lower the downside of both options.
Small business financing: debt or equity
Small Business Financing (also known as startup financing) is essentially a monetary source for the business owner to start a business or bring money into an existing business. There are two ways of financing a small business:
Debt financing: When you take a loan to purchase a house or car, or travel, it is called debt financing. As a business, when you take out a loan to fund it, it is also a type of debt financing. When opting for debt finance, you have to pay the loan along with interest.
Equity financing: When you finance your business with equity financing, you gain funds against the equity. Investors offer equity financing by purchasing your company’s shares.
if you’re wondering what you should choose for your small business - there’s no one right answer to this. Most small businesses choose between one of the alternatives; some even go for a hybrid route.
Ultimately, what kind of funding you pick for your small business depends on your individual preference - do you dread giving up control of business decision-making? Do you need cash upfront? Are you keen on absorbing all of the profits without having another “hand in the pie,” so to speak? if yes, debt financing may be a brighter alternative of the two, especially, if you’ve been in business long enough to establish a degree of credibility.
What is better for my business, debt financing or equity?
As mentioned previously, it all depends on the kind of funds you require, your business size, and the accompanying conditions you’re willing to meet. If you just need a few thousand dollars, it is simpler to borrow from a friend or family member or take a bank loan. However, if you need millions, equity financing may be a more prudent, long-term option.
Most companies require some debt financing. Extra funds help businesses to invest in the sources they need to grow. Startups and new companies require access to capital to purchase tools, machinery, supplies, property, and inventory.
The primary concern with debt financing is that the borrower should ensure they have sufficient cash flow to pay both principal and interest debt together. As long as that condition is met, there is no reason why a business should not opt for this financing option, considering it is also one of the safest routes to securing the company’s ownership while scaling it to the desired level.
If you’re looking for more information on debt financing and how it can prove fruitful for your business, call us at +91-9819660287 or drop us a query in the form here.