There are three main routes that businesses can take to raise funds: debt financing, equity financing (which means selling shares in your company to investors), or a hybrid of both. This is a guide to debt financing: what it is, what kind of businesses it’s suitable for and how to go about getting it.
What we're talking about
Debt financing raises money by taking on some form of loan that has to be paid back – with interest – at some point in the future. These loans typically fall under three categories: installment loans (monthly repayments on a set period of time); revolving loans (access to an agreed upon line of credit as and when you need it); and cash flow loans (access to funds based purely on the business’ expected cash flow). They come short term (paid back within 6-18 months); medium term (3 years); or long term (5 years).
Traditionally a bank would be the place you would head cap in hand, so to speak, to try and get a loan. They offer a few main types of debt financing:
Bank loan – a set amount of cash given to the business with fixed interest rates and a repayment schedule.
Business credit card – which works like a personal credit card (though often with higher interest rates), with approval based on your personal credit history.
Business line of credit – which gives access up to a fixed amount of cash whenever you need it with interest only paid on what you borrow.
Equipment financing – which is a loan or a lease to purchase or borrow physical assets.
Though banks might still be the first port of call, long gone are the days when they were the only avenue. Newer debt products have emerged that provide access to finance based on recurring revenue – and are not always dependent on having assets, like property, that you put up as collateral. These options can be a better bet for a business that hasn't been around as long — provided it’s already making some money.
These options include:
Factoring – a lender gives you a percentage of the funds you’re expecting from a customer – they then pay the remaining amount when the customer pays, minus their fee.
Revenue-based loans – you get a fixed amount of cash and pay a fixed percentage of ongoing revenue to pay it back.
Inventory loans – you use your inventory and assets to secure funding – up to the maximum value of that inventory.
Accounts-receivable loans – you get funds based on the money that’s owed to you by customers who are yet to pay (AR).
E-commerce loans – you get funds, normally for attracting new customers, based on sales and advertising spend data that you provide.
Why it's important
The truth is that many businesses have been – and continue to be – built using debt. So knowing what options are available and suitable to your business – and how much it’ll cost you – is absolutely essential. The critical thing to note is that by and large debt financing is only really suitable for businesses that are already generating revenue, or about to. Getting a loan is not easy – lenders will often not even entertain the thought unless the business has a stable stream of revenue, and a past track record of it, to ensure repayment. If you find yourself in that position and able to secure a loan, debt has plenty of uses – no matter a business’ size or scale. For example, it can help tide the business over during quiet periods; refurbish premises; upgrade or lease equipment; or get advances on sales invoices.
Whether taking on debt is right for your business is evidently depending on where you are in your lifecycle, as regards to revenue. But there are a few other things to consider, summarised by the key pros and cons of debt.
• You maintain control and avoid dilution of your ownership. That means you can run your business how you see fit and, if you do one day sell the company, you won’t have to pay out to investors. • Once you’ve paid back the debt, your liability is over. That means it can be far cheaper to the business (cost of capital, see below) than equity – though that of course depends on the terms of the loan. It can’t be emphasised enough those terms can vary. • In most cases, the interest you pay on your debt can be classed as a business expense – meaning you can deduct it from your income tax when tax time rolls around. This is only really a perk when the business has grown and you have a sizeable income coming in.
• The vast majority of loans are secured - meaning to get the loan, you need some form of collateral. That could be equipment, real estate, inventory, accounts receivable or a personal guarantee. And repayments have to be met even if the business falls on hard times or fails – meaning you may well have to risk personal assets. • Interest rates can be high – and can fluctuate over time unless fixed. They can depend on macroeconomic conditions, your business or personal credit history, and the loan type. Rates can range from 2.5%, for government-backed loans, to eye-watering triple digits (!) for merchant cash advances. • Taking on too much debt can impact profitability and, by turn, the valuation of your business – making it a less appealing proposition for investors if you do one day decide to sell.
If you’re weighing up whether to go for debt or equity – and potentially even have both options on the table, it’s important to understand the Cost of Capital. Whether you’re using equity or debt to finance your business, you have to pay it back. The Cost of Capital is exactly what it sounds like — the cost to the business to take on those external funds. There are equations to work out the cost of debt, cost of equity or a weighted combination of both, but the key thing to remember is that the cost of debt is interest, and the cost of equity is the eventual value of the proportion of your business you give up to get that crucial capital.
How to pursue debt financing
Now you understand the basics and what debt can do, you might feel you want to explore the debt financing options available to you. Here are the next steps:
1. Analyse your business’ position. Decide whether you’re at the right point in your business’ life cycle to raise debt. Based on the information above, are you in a financially sound position where taking on debt is a) feasible, and b) what you want to do for the long term strategy of the business? You’ll likely need recurring revenue, customers who pay on time, a healthy cash flow and some form of collateral to secure a loan. To find out what debt your business is suitable for, check out this simple interactive tool.
2. Decide what type of debt is suitable for your business. Sit down and get calculating: what will the funds go towards and how much do you need to borrow to achieve those goals. What, based on your projected growth forecasts, is a realistic time period to pay the loan back? Remember: the more you borrow, the more you’ll have to pay back. Now is the time to have that first conversation with a bank or lender.
3. Shop around to see what terms are available.
The more options you have, with the varying terms they’ll offer, the stronger your position will be. Along with speaking to your bank, you can discover what bank loans might be available to you at an online marketplace (Funding Exchange for UK options; Lendio for US). It’s also worth seeing what alternative debt products are available – Funding Options (UK) and INTRO (US) are good places to start.
4. Calculate your cost of capital.
If and when you get loan offers, calculate your Cost of Capital: how much that loan is going to cost your business based on the interest rates offered. If you have an offer of equity also on the table, now is the time to compare and contrast and weigh up the pros and cons of both. Cleverism have a detailed guide including a downloadable Excel spreadsheet to help work out your Cost of Capital.
5. Decide whether it makes financial sense.
It’s time to decide whether the cost of capital – and the repayment terms of the loan – are acceptable and realistic to your business. Do the terms of the debt make sense for what you’re trying to build and how much revenue you project will be coming into the business? This is critical – as mentioned, interest rates can be high and you have to pay the debt back, no matter what.
• There are numerous forms of debt financing available now, and options are not limited to the traditional bank loan. What type of debt your business is eligible for depends on several factors but without recurring revenue, it’s extremely difficult to get any form of loan.
• There is, naturally, a high amount of risk associated with taking on debt. The vast majority of loans are secured – that often means putting up personal assets – and repayment has to be made. On the flip side, debt allows you to keep control of your business and grow at your own pace.
• How cheap debt is compared to equity will depend on the terms you secure. You’ve got to shop around to see if you can get a good deal as interest rates in most countries are low right now — just make sure you’re absolutely clear on how much it might end up costing you.
Learn more about debt financing
Delve deeper into the differences between debt and equity with this online short course from Rice University which surveys key topics covered in a MBA-level finance course. For an in-depth take on why debt might be useful for the early stages of a company, Mesh Lakhani has written an excellent blogpost on the subject.
If you want to compare your cost of capital or debt-to-equity ratio against the industry standard, Bizstats offer free statistics across all sectors of small business.
Explore what financing options may be suitable for your business with this interactive tool.
Learn about the alternative debt financing products on offer at INTRO – a newly launched platform connecting businesses with the solutions that sit between VC funding and traditional bank loans.
Calculate your cost of capital with Cleverism’s detailed guide and downloadable Excel spreadsheet.
For some real life examples of people who have used debt financing to grow their business, listen to our Workshop podcast on debt financing.