Scale Your Business with Debt Funding

 

Debt financing is common funding for many businesses. If you are an entrepreneur trying to raise capital for your business , looking for the right funding does not have to be complicated. The better way to avoid the difficulties of raising debt financing is to understand it before you move further such as what the difference is between debt capital and equity financing. At the same time, you will need to make sure that the terms of the loan that you are going to get are in your favor so that you can pay back your debt as fast as possible. Here, you will learn about debt funding and how to use this debt instrument to effectively manage and expand your business.

What is Debt Funding?

Most businesses don’t have access to capital markets especially for equity investment. Debt funding is usually much more accessible for small businesses due to the smaller risk for lenders. Debt funding occurs when you borrow a sum of funds from an outside source. Then, the debt is repaid with interest at agreed terms and conditions. The payments can be made monthly, yearly, or towards the end of the loan terms. However, you also have to consider the length of your loan term.

Short-Term Debt Funding

If you want to finance your business but do not want a big loan with interest and a long repayment period, then short-term debt funding is what you need. Short-term debt funding is typically used to fund a project that will not only produce short-term revenue but is also a key aspect of the overall business strategy. Through this, businesses are allowed to borrow money that is payable within a year and with a minimal interest rate. Most of the time, this type of loan is used for paying your rent and employees, or for buying additional materials and supplies.

Long-Term Debt Funding

Long-term debt funding is a debt arrangement with a loan term of more than one year. What is good about this type of debt funding is that your cash flow would not be greatly affected because your monthly repayment is lower. However, it entails collateral risks. You need to use your other assets to avail this type of funding. Along with potential property loss, you might need to pay penalty fees if you start missing out on your monthly dues.

Why is Debt Funding Important for Startups?

With the current economic climate, small businesses and startups are finding themselves struggling to keep running. Although you can build and run a flourishing business venture even without funding, the reality is that you can achieve and scale your business goals faster through debt funding. That is where debt financing comes into play. Raising growth capital enables you to grow and quickly ramp up your business operations.

Meet Business Financial Goals

Every business has goals. It is easier to set your business plan if there is enough funding in the process. With debt funding, you can maintain your cash flow, venture into new business opportunities, and stay ahead of your competitors. You can also expand your business or get needed equipment.  All are beneficial to you in the long run even after you are done with your loan payments.

Generate Enough Cash Flow

Cash flow is the money that flows around your business from operations, funding, and investing ventures. When you do not have healthy cash flow that means your business might be having a hard time meeting its financial functions like paying your suppliers or staff. 

Improve Your Business Standards 

Competition in the market has gone up. It is essential to match your business standards to the standards of the business industry. The better and more reliable your source of funding is, the more competitive your business will be. Having enough funding gives your business flexibility and versatility which also allows you to make additional revenues and get ahead of your competition. 

How Does Debt Funding Work?

In debt funding, the lender lets an entrepreneur borrow his/her funds for a specific period. But before the lender gives the money to the borrower, they need to come up with terms and conditions on which both of them should agree on. Usually, terms and conditions include payment schedule, interest rate, and penalties if ever the borrower fails to pay the borrowed money on an agreed date. Once the agreement paper or the contract is signed by both of them, the borrower can use the money for his/her business plans. These funds can be used as working capital, purchase tools, for inventory purposes, and for business expansion. In order to have that extra funds and take your business to the next level, you have to thoroughly study the appropriate debt funding that will be beneficial to your business.

Before you decide, you must have a clear idea of what loan programs will suit your business. To better comprehend how debt funding works, these are the three main forms of loan programs that you have to consider:

Installment Loans

Installment loans are offered in mortgages, car loans, and personal loans. It provides a borrower with a fixed amount of money that must be paid on a regular schedule. Each payment on an installment loan involves repayment of an investment loan or principal amount borrowed with interest rates. Then, it indicates the cost of the loan, the interest rate charged to the borrower, and the length or term of the loan. Your regular payment schedule is the same throughout the loan term. So, it is easier to budget in advance to make payments.

Revolving Loans

These loans can come from credit cards where you can use your balance monthly. You can borrow capital up to a fixed credit limit while the interest rates are subject to change. Your monthly payment varies on revolving loan and depends upon how much you currently owe. As you repay your balance and interest, you can borrow repeatedly.

• Business Line of Credit. It is a flexible loan offered by a bank where you can request a certain amount of funds based on the agreed terms. You obtain these funds as needed and then you can repay them promptly within a specific period of time. You only owe interest with the amount that you borrowed. You can borrow funds as long as you do not exceed the maximum amount set in the agreement. 

Cash Flow Loans

It allows you to borrow funds against the revenue that you expect to earn in the future. This funding provides you the capital to be repaid quickly. It is used for short-term business solutions like replenishing your inventory, ensuring your product availability to fulfill bulk orders, and when you want to upgrade or replace equipment or assets. This can help you sustain your business when you have insufficient sales or profit.

Repayment of Loans

There are 3 ways to pay off your loans and it depends on the initial loan agreement you’ve signed. The main difference is how the principal and interest expense are being repaid.

Interest-Only Payments

These types of loans requires you to pay the interest accumulated on the principal. The principal doesn’t need to be repaid until the end of the loan period. This reduces the amount you as the borrower needs to repay on every month, giving you more cashflow. However, do note that you will need to pay the principal amount at the end of the loan, which requires you to hold a substantial amount of liquidity as your loan term ends.

Principal and Interest Payment

In these types of loans, your repayments goes towards both the principal and interest amount. Most lenders prefer this sort of capital structure as it is of the least risk to them. However, you as the borrower will less likely to be able to tap on the full loan amount for your business growth especially if the loan repayments start the next month after the loan is agreed upon.

Deferred Loan Payment

This is the least common type of loan repayment scheme because lenders carry the most risk. You will begin the loan repayment after a period of time of starting the loan term. The delayed loan repayment can be both the principal or interest component, principal only, or interest only.

This is my favourite loan structure because for most businesses, you will only start to make money after a certain period of time when you have invested the loan amount. For example, in eCommerce business, when you borrow to purchase inventory, there is the manufacturing time, shipment time and for your inventory to be cleared before the profits from the inventory goes back to your bank account.

I usually structure these types of loans when borrowing from friends and family whom are more likely to trust you. For example, I will structure a one year loan to only start repayments after 6 months for both the principal and the interest amount allowing me to capitalize on the full amount for business growth.

When to Use Debt Funding? 

Raising debt funding requires distinguishing the needs and expenses of your business. This is important because there are different types of debt funds available. To raise debt funding and use it effectively, you need to focus on the nature of funding options to avoid risking your assets or paying high-interest rates. You can use debt funding to:

• Gain Access to Flexible Funding Options. You can get the funds you need to grow your business through a process. Debt funding options tend to be less complicated because there is less compliance and you do not have to go through the process of screening your business associates or process of discussion regarding an agreement in ownership.
• Evaluate Your Financial Situation. Most of us just estimate the amount of budget needed to fund a business which can lead to overspending. So, it is important to evaluate your needs because you will never hit your target if you do not know your financial needs. When you evaluate your financial situation, you need to list down all your needs, finances, and income sources so that you can picture out your financial situation. It gives you an idea of what type of debt funding is best suited for your business. 

5 Factors to Consider When Raising a Debt Funding

There are plenty of low-cost funding options out there. However, if you are planning to use debt funding, you have to understand what path you will take. Before you choose the appropriate type of debt funding for your business, there are a number of factors that you should be conscious of when raising debt funding. I enumerated below the various factors you have to contemplate when you want to apply for debt funding.

Long-Term Goals

Start asking these questions: “What are my long-term objectives? Can debt-funding help me achieve all these goals?”. Your goals can be the things you want to have or get after 5 or 10 years. Knowing your long-term goals enables you to identify what are the necessary steps you need to undertake to achieve these. Aside from that, your long-term goals help you decide whether you need debt funding or not. 

Current Business Income

Another factor that you have to view is your current business income. Your business should have the capacity to pay your debt as well as to comply with the agreed terms and conditions.

Requirements

When you decide to get a loan, you have to submit the necessary requirements to get your loan approved. Some of the requirements can be your fixed monthly expenses, business plan, and many more. 

Interest Rates

Interest is essentially an additional charge that you need to pay aside from the borrowed money you get. If your business has access to low-interest rates, the total cost of borrowing is lower. On the other hand, you may also need to pay higher interest rates if you opt to get big loans from banks and other financial institutions. So, you have to match which funding opportunities can considerably benefit your business venture before reaching your final decision.

Repayment Terms

Many business loans offer simple loans with a fixed interest rate. Some of these loans will not require any repayment for several years against your loan. There are also loans with repayment terms that are complicated. If you borrow from a venture capitalist or angel investor, they may give additional terms that are not found in conventional bank loans. Sometimes, these investors offer a mix of debt and equity funding for new businesses.

Different Types of Debt Funding 

There are distinct ways you can use debt to fund your business. As you weigh whether debt funding is right for your business, we have covered seven kinds of debt funding. Here we will break down those funding options to know where you can find each type of debt funding source. 

Borrowing Money from Family and Friends

One of the convenient ways to get funding for your business is from your friends and family that you trust. To avoid discrepancies, you should treat your agreement terms professionally because your funds are not only at stake but also in your personal relationships. You need to set a detailed plan for how you plan to pay off your debt to them and create documentation for record purposes. 

Financial Institution Loans

Financial institutions include banks, credit unions, and finance companies. They all offer loans and they could provide you with a variety of deposit, lending, and investment products. To qualify for this type of bank loan, you have to comply with their demands. Most banks preferred to lend their funds to established businesses with a proven track record. The loan may be provided for a specific purpose such as buying or upgrading your business assets, and onboarding new staff. Most of these types of loans are revenue based financing. Companies like Lighter Capital offers debt financing based on business revenue.

Peer-to-Peer Lending

Peer-to-peer lending, also called crowdlending, is a type of funding that connects people that are interested to loan money directly with people or businesses. Your interest rate and terms will base on common factors that other lenders consider like your credit score, credit history, and income. Nowadays, you can now use online platforms like Validus, Capital Match, and Minterest to apply for this. 

Home Equity Financing

In a home equity loan, you can borrow funds using your real estate property as collateral. You should have a stable credit record so that you can qualify for the loan. This type of loan can provide you with funds in the form of a lump-sum payment that you have to repay with a fixed interest rate. Here, your payments will be higher since you have to repay both interest and principal amounts over time. 

Business Credit Cards

Business credit can help cover your continuing expenses primarily if you have a startup business that cannot qualify yet for a loan. You can use credit cards to build your business and use them to earn trust for your future lending partners. It also eases your burden on invoices because only a single monthly bill is paid out. Take note that using this type of funding may lead to higher interest rates if you use it for cash advances and you have late repayment.

SBA Loans

Small Business Administration (SBA) loan is a small business loan that is partially guaranteed by the government. It eliminates the risk for the financial institutions who are issuing the loan. SBA works with approved financial institutions like traditional banks that lend money to small businesses. They offer better terms because the SBA partially guarantees the loans that these lenders extend to small businesses. As a result, lenders are able to offer more adjustable payment terms and lower interest rates.

Business Line of Credits

It can be used for your short-term funding needs like for purchasing inventory or fixing your damaged equipment. Business lines of credit work much like a combination of a credit card and a term loan. In this type of funding, the lender grants you a set of funds, or credit lines, which you can use whenever you want. You only have to pay interest on what you borrow. When you repay your debt back in full, it resets to your original account balance. 

Venture Debt Financing

Venture debt are term loans offered by angel investors and venture capital. Rather than having equity capital in your business, they provide you with short term debt financing for your business. This way you do not have to risk equity ratio in your business.

Advantages and Disadvantages of Debt Funding

Each type of debt funding has advantages and disadvantages, finding the appropriate funding can be difficult and stressful. To encourage you to decide wisely, let’s take a closer look at the advantages and disadvantages that you need to keep in mind.

Advantages

In debt funding, you can maintain control of your business. Lenders only help you to fund your business operations unlike equity financing, the investor becomes a co-owner of your business. It means they will be involved in the decision-making. You can sustain good payment history, increase your business credit and improve your business credit score. This credit score is important to grow your business’s financial profile and increase your chances to qualify for other types of debt funding. By using this method you can plan in advance your monthly, quarterly, or annual payments. This means you can easily budget your principal and interest that needs to be repaid each period. As a result, you can have an edge in making your financial plans to predict projected costs for your business. There are also possible tax deductions that are available to all types of business owners, including sole proprietors and partnerships. Many of the costs of funding a loan, like origination fees are also tax-deductible. These tax advantages could also stand to lower your interest rate.

Disadvantages

You have to be aware that when you cannot pay back the loan, your business or personal assets are at risk. Then, if you have insufficient business collateral, the lender may require you to sign for a personal guarantee. Lenders use personal guarantees to ensure that the borrower can get personally responsible for repaying the loan. So, if your business ends up having a hard time paying back loans, the lender can seize your house or personal savings. When you use debt funding, you must have the discipline to make your payments on time. It is important to have a commitment and good financial judgment because you can have difficulties growing your business while making your monthly, quarterly, or annual payments to your loan. In addition, if you have a loan with an interest rate, the amount that you end up owing your payments can fluctuate which can impact your cash flow.

Final Thought

If you have great business ideas it is better to start raising funds. There are various options available that you can get and avail of when it comes to debt funding. It can give you a huge amount of capital but comes with high interest and high expectations or you can choose lower interest loans but can give you a lesser amount of funds. Deciding to raise capital through debt funding is a decision that can greatly impact the future of your business, taking advantage of it can lead to more business opportunities and growth. As you contemplate the advantages and disadvantages, consider not only what you will gain, but also the risks that are involved. Whatever you choose among the above-mentioned debt funding options, I suggest that you have to find what is suitable based on your business needs that will benefit your business.