There’s one thing nearly all startups and small businesses have in common: at some point, the vast majority of them will need to seek financing for working capital. It can be difficult to cover business expenses as you experience growth. The key is to make wise financing decisions when those expenses mount.
One option you have when your business is in need of working capital is known as debt financing. Below, you’ll find details on what debt financing is and the pros and cons of taking advantage of this option. You’ll also find details on other financing options and answers to the most common questions about debt financing.
What is debt financing, and how does it work?
By definition, debt financing is the process of raising funding by selling debt instruments to investors. However, that definition can be a bit misleading.
Small businesses and many startups don’t have access to institutional investors and venture capitalists who are willing to provide debt financing. Instead, many businesses look to lenders, peers, friends, and family.
Debt financing can be as simple as borrowing money from a bank or a friend, or it can be as intricate as taking out a home equity line of credit or taking advantage of merchant cash advances.
Nonetheless, debt financing always follows these three basic principles:
- You get the money you need.
- The lender earns interest on the loan.
- You must pay the loan as agreed either over fixed monthly payments, variable monthly payments, or in full at the maturity of the loan.
Pros and cons of debt financing
Before you choose any financing option for your business, it’s important that you consider the pros and cons. After all, financing opportunities all come with risk, and if you overstretch your business with too much debt, it could have a detrimental effect on your company’s survival. Here are the pros and cons you should consider:
- Get the money you need: Debt financing gives you access to the money you need, and it typically does so quickly.
- Familiar financing: Most people, business owners and consumers alike, are familiar with loans. You may have credit cards, an auto loan, a mortgage, or other loans, all of which are debt financing from a personal finance perspective. This familiarity may make it easier to understand the terms of debt financing for businesses.
- Retain control: You don’t have to give up any portion of your business for access to most debt financing, so you remain in control.
- Easy planning: With debt financing, you know how much you pay in interest and principal repayments every month. This makes it easier to handle financial planning for your company.
- Rising interest rates: Most debt financing vehicles charge interest rates as the return to the lender. As interest rates continue to rise, the cost of debt financing follows, making these products less and less attractive.
- Collateral: In most cases, you’ll be required to put something of value up for collateral. That means you may have to risk equity in your company or other assets to secure access to the money you need.
- Qualifications: It may be difficult to qualify for traditional bank loans and other forms of traditional debt financing. Lenders will consider your personal credit rating, business credit rating, and several factors associated with your business before approving your loan.
Types of debt financing
Although all debt financing products tend to follow along the same lines, they’re not all the same. Sure, they get you the money you need, give you time to pay through structured payments, and profit the lender, but there are several different forms of debt financing.
It’s important to consider all of your options to determine which is best for your business. Find the details of the most popular debt financing options below.
Traditional bank loans are also commonly called term loans. The process is simple. The financial institution gives you the money you need and you agree to make monthly payments over a fixed period of time that include principal and interest payments.
For example, you may take out a $50,000 bank loan with a 14.99% interest rate that you agree to pay in full over the course of five years. You get the $50,000 you need now, and you pay about $1,183 per month for the next five years to pay the loan off.
Recurring revenue loans
Recurring revenue loans are loans that are underwritten based on the amount of recurring revenue your company generates, rather than your business’s credit score and assets. This is a beneficial option if you’re in a business that generates regular recurring revenue, like software-as-a-service businesses.
Peer to peer
Peer-to-peer lending has a name that says it all. These loans work just like bank loans, but there’s no bank involved. Instead, you use a peer-to-peer lending platform to find investors who are interested in providing the funding you need in exchange for the interest you would typically pay to a bank.
These loans may be easier to access than loans from traditional lenders and are more attractive to borrowers who may not qualify to work with traditional financial institutions.
Small Business Administration loans, also known as SBA loans, are business loans provided by financial institutions, but guaranteed by the Small Business Administration. These loans make funding more accessible to small businesses while posing less risk to financial institutions.
You can use SBA loans for a wide variety of reasons like covering your startup expenses, working capital needs, real estate, expansion, and more. Check out our SBA loan calculator tool for to test out different payment terms and structures for your business.
Friend and family loans
Financial institutions and peer-to-peer lending platforms aren’t the only places to find debt financing. Friends and family are often great sources of the funding you need. Moreover, these lenders typically don’t care about your credit rating and have more reasonable terms than other lenders may have.
Line of credit loans
A line of credit is a revolving loan, much like a credit card. They come with credit limits, and you can access them whenever you need them. These loans also come with variable payments based on the amount of money you’ve borrowed.
83% of Americans have at least one credit card, while the average American has three of them. However, credit cards interest rates are notoriously high, so you should only use them to cover expenses you can pay back in the short term.
Credit cards are also an effective way to build business credit and qualify for better lending options — that is, as long as you use them responsibly.
Who should use debt financing and when
Debt financing is a strong option for business owners who:
- Need money quickly
- Can meet the qualifications to access debt financing
- Are financially disciplined enough to meet minimum payment requirements
- Are not interested in giving up an equity stake in their company
If the above describes you, you should use debt financing for things like:
- Funding major equipment expenses
- Working capital for day-to-day operations
- Funding acquisitions and other forms of inorganic growth
- Funding innovation and other forms of organic growth
Also, if you decide debt financing is best for you, it’s important to choose the type of financing that fits your unique needs. Consider the following:
- Think of your ability to qualify for traditional forms of debt financing. If you have the profitability and credit score to qualify for a traditional bank loan, it may be the lowest-cost way to go.
- SBA loans are a low-cost alternative to traditional bank business loans. However, they take some time to process. If you’ve got the time to wait, this may be a compelling option for you.
- Next, consider your business type. If you operate a business that generates meaningful and growing recurring revenue, a recurring revenue loan may be your best option if a traditional loan doesn’t fit the bill.
- Peer-to-peer lending may be another strong option if you don’t qualify for a traditional bank loan and don’t have the recurring revenue required for recurring revenue loans. Also, consider accessing the funding you need through friends and family.
- If you don’t need much cash, and have the ability to pay what you borrow back quickly, credit cards may be your best option.
Alternatives to debt financing
Debt financing may be the most familiar financing option to you, but it’s not the only option you have. Find the details of alternate funding options you should consider when you need money to start, sustain, or grow your business.
Equity financing is the process of selling an equity stake in your company to shareholders in exchange for the funding you need. This typically involves putting together financial statements, like balance sheets and cash flow statements, and meeting with accredited and institutional investors in hopes that one will make an investment in your company.
They’ll use metrics like your debt-to-equity ratio, liabilities, and more to determine a fair business valuation when they invest.
Invoice factoring, commonly called accounts receivable financing, gives you the ability to tap into cash flow from work you’ve already provided before invoices are due. Invoice factoring providers essentially buy the rights to your invoice income at a discounted rate to the total value of the invoices they buy.
Although invoice factoring helps you avoid debt, it can be more expensive than debt financing options.
Accounts payable financing
Accounts payable financing is a type of financing that gives you the money you need to pay your suppliers today. You pay back the loan over time as you sell the inventory you purchased with the financing.
Credit cards with sales-based underwriting
Card providers offering commerce-based sales underwriting makes it possible to access higher credit limits than traditional cards offerings. Lenders of these loans use data from providers like Shopify, Stripe, and other payment platforms in their underwriting process, making it far easier to qualify for than traditional loans.
Find out how Ramp can help
Getting a business loan can be a painful process. You may wait weeks for the underwriting process to be completed only to find out you don’t qualify for the credit limit you need.
Ramp takes a different approach to getting the funding you need. The company’s commerce-based sales underwriting process for its cards is fast and painless and is known to offer high-growth companies up to 30 times more than traditional financing options.
Moreover, when you work with Ramp, you get access to free best-in-class software that helps you manage your expenses and payments, and it integrates seamlessly with accounting platforms to help you control, monitor, and deploy spending in real time. Ramp can also connect you with its financing partners to give you access to the long-term funding you need.
Both debt financing and equity financing can get you the money you need to start, sustain, or grow your business. The difference is in how you pay the money back.
- Debt financing: The return on investment for the lender is the interest and fees you pay for access to the money. You pay this financing back in full, plus interest, over a predetermined payment schedule.
- Equity financing: The return on investment for the investor is a share in your company. That means they share in dividend payments and benefit from the company’s growth as partial owners. Moreover, they must be paid their share if your business is acquired.
An example of debt financing would be borrowing $25,000. In exchange, you agree to pay 15.25% interest and make monthly payments for three years. In this case, interest and principal payments would total about $869 per month.
If you fail to pay back debt financing, you will harm your business and potentially personal credit score. In the best-case scenario, that’s the only risk. However, most business debt financing is secured with collateral.
If you fail to pay a collateralized loan, you will lose your collateral. That may mean you’ll have to give up a percentage of your business, key business manufacturing equipment, or even your home.
Always consider the risks before you accept funding.
Although business debt itself isn’t tax-deductible, the interest you pay on business debt is. So, keep track of how much interest you pay each month to claim your deductions.