What is Debt Financing?
Are you considering starting a new business or refinancing your existing business? Read this article to learn more about debt and other financing options.
There are a range of reasons why a business might need to seek finance. They might simply need to purchase stock or want to fund a significant expansion. Often, seeking finance is a process which allows a founder to begin the set up of a business rather than it remaining an idea.
Debt financing is one of the most common methods of financing. Whichever your purpose for seeking finance it is an important method to consider. In this article, we’ll examine the process of financing with a particular focus on debt financing.
What is Financing ?
Financing is the process of a business getting money that it can use for business activities. This process generally involves the business giving up something in exchange for the money. There are many methods of financing but the most common are debt and equity financing.
Debt financing is where a company gets money or ‘finance’ by agreeing to repay that money and interest in the future. In other words, the company incurs debt and an obligation to repay that debt, in exchange for money given to it today.
Repayment of debt often occurs on a regular schedule over an extended period of time. This structured process of repayment may suit some businesses but not others. Eventually, when the business repays the debt and the relevant interest, the business doesn’t need to speak to the lender again unless it chooses to.
Business A debt finances by going to the bank and getting approved for a loan. The loan is for $50,000 and will last 10 years at 8% interest. Upon receipt of the $50,000 the business will be obligated to repay the loan at the regular intervals the bank tells it to. This might be twice a year or quarterly or even monthly depending on the loan.
Advantages of Debt Financing
There are several advantages to debt financing:
- Interest on a loan is tax deductible as it is a business expense.
- The lender does not own any part of your business and therefore has no say in how you run it.
- After you pay the debt back, you have no further relationship with the lender.
- The business knows the cost of the loan and its repayments for current and future periods. This better allows the business to make financial decisions and forecasts.
Disadvantages of Debt Financing
There are also disadvantages to debt financing:
- Fixed repayment amounts assumes a business is able to afford those repayments. Small businesses and startups do not often have the regular kind of income required to service this debt.
- Small businesses and startups are vulnerable to economic downturns. Regular debt obligations could increase pressure on businesses during these times.
Equity Financing is the process of getting money for business activities in exchange for ownership in the company. Companies using this financing method often issue shares to an investor or multiple investors. These shares might be provided to a private investor or to the public in the form of an initial public offering or IPO.
Company B is a startup that wishes to finance its expansion. Company B sells 10% of the company to an investor in a venture capitalist presentation. In exchange for that 10% ownership, the company received $100,000 valuing the company at $1,000,000. Depending on the terms of the agreement the investor may have a say in aspects of the business.
Some advantages of equity financing are:
- Doesn’t require the business to make regular repayments. This is less risk for the business.
- Does not limit a business’ cash flow. This allows the business to reinvest all profit into the business’ expansion and more easily pay its bills and other debts.
- You can get it without having to prove your credit risk. Banks and other lenders will often require proof you can pay the loan back or, in order to account for this risk, adjust the interest rate higher. By giving up equity businesses avoid these problems.
Some disadvantages of equity financing are:
- Equity investors will expect to receive a share of company profits. This might be more expensive than any interest paid on a loan.
- By giving up equity a business owner gives up some control of the business. Equity partners will want to have their say in the operation of the business. This might depend on the agreement struck but will generally always include big decisions facing the business.
- Having more business owners may lead to disagreement. This may hamper the business.
Alex is a Legal Tech Intern at Lawpath as part of the Content Team. He is in his fourth year of a Bachelor of Laws with the degree of Commerce (Majors in Entrepreneurship and Accounting) at Macquarie University. He is interested in Corporate and Commercial law.