Debt funding occurs when a firm raises money without offering equity; this often occurs when a company requires money for working capital or capital expenditures, which it acquires through the sale of debt instruments to individuals, institutional investors, financial organizations, and some venture capital firms. In this case, the individual or institution lends the money and becomes a creditor of the company acquiring the money, receiving a promise from the borrower that the principal will be repaid in a given period of time and with interest. Debt funding is often considered an alternative to equity financing (or raising money in return for equity shares of the company).
Generally, in the case of a company attempting to raise capital or meet cash flow needs, there are three ways to obtain financing: sell equity, take on debt, or a hybrid of the two. A company can choose equity, but in the case where either the business does not garner interest for its equity or the ownership of the business does not wish to offer equity, debt funding allows a company to raise capital without concerns around equity. Debt funding entails selling fixed-income products, such as bonds, bills, or notes, to investors to obtain the capital needed to grow and expand operations. As well, once the loan is paid back, the relationship a company has with its creditors or financiers ends. The interest paid is tax-deductible.
Debt and equity funding tend to be often compared because they are commonly considered two of the most common ways for entrepreneurs to raise funds for a new business. Debt funding gives the entrepreneur a chance to raise the necessary funds, paid back in interest, without losing any control over their business (or losing less equity than they would through equity funding. Whereas equity funding allows an entrepreneur or their business to acquire funding in exchange for a share of the company. Both come with their own advantages and disadvantages, which the individual or business can consider before raising the funding.
When choosing debt funding, businesses can choose from debt instruments that offer debt funding for short-term and long-term periods.
Short-term debt funding tends to be debt funding used for working capital for a business's day-to-day operations. This could be used for paying wages, buying inventory, or costs incurred for supplies and maintenance. These types of debt funding tend to have a repayment period within the year. A common type of short-term debt funding includes lines of credit, which is secured with collateral and can be used to help businesses with positive cash flow.
Businesses can choose long-term debt funding instruments when they need more cash flow to purchase assets, such as buildings, equipment, and machinery. The assets that will be purchased are also used to secure the loan as collateral. These loans have scheduled repayments for up to ten years and with fixed interest rates and predictable monthly payments.
In an installment loan, the business receives funding from a lender up front and is required to repay the principal with interest over a fixed period of time and based on an established payment schedule. This is also referred to as a traditional term loan. These types of loans can be secured or unsecured.
In a revolving loan, the borrower has access to a set credit line that can be drawn from and used as needed. Interest on this loan is only paid on the funds used, and once repaid, the credit lines reset. Credit cards are an example of a revolving loan.
Cash flow loans are any type of loan that gives the borrowing business an advance of funds based on business revenue. Some lenders will consider business bank account data, and others may look at recent cash flow and use these to offer funds against future sales. Invoice factoring and merchant cash advances are examples of cash flow loans.
Depending on the region the business operates in, there are several institutions that can provide debt funding opportunities for a business. Some regions require banks to have a limited amount of business debt balanced out by other measures, meaning they are limited in their ability to provide companies with debt instruments. However, in such a region with bank restrictions, other companies, types of banks, or debt funding opportunities can arise. This means companies typically have a lot of choices when raising debt funding, including those below:
Types of debt funding providers
There are several options for debt funding a company can choose. Each comes with different considerations a company has to make to find the debt funding that suits the needs of the company, both for the short and long term. Some of the common types of debt funding include the following:
Business term loans are a standard type of debt funding and operate in a manner similar to a car loan or mortgage. With a term loan, a business is able to borrow a lump sum of capital for a specific purpose, which is then repaid with interest over a set period of time in fixed, equal payments. Term loans are considered to be well-suited for business renovations and business expansions, while some loans can be designed to facilitate specific business purposes such as equipment financing or commercial real estate loans.
Similar to a business term loan, bond issues are a form of debt funding. A traditional bond certificate includes a principal value, a term in which the repayment must be completed, and an interest rate. Bond purchasers then become creditors by loaning the money to the business.
SBA loans are small-business loans issued by participating lenders—typically banks and credit unions—and are partially guaranteed by the U.S. Small Business Administration. The partial guarantee reduces the risk for lenders and is intended to help incentivize those lenders to work with small businesses. There are various types of SBA loans, but generally, they are structured as term loans. Further, the U.S. Small Business Administration sets guidelines for these loans, including maximium loan amounts, repayment terms, and interest rates. These are generally considered to be good debt funding options for smaller businesses needing to raise capital for working capital needs, business expansions, and equipment purchases.
A business line of credit offers a business a set amount of funds to draw from and acts like any other line of credit in that once the borrowed amount is paid back, the business line of credit resets to the original limit. Business lines of credit are a flexible form of debt funding, allowing businesses to use them for managing cash flow gaps and covering operating expenses.
Business credit cards operate similarly to a business line of credit, giving access to a set amount of funds that can be drawn from to make purchases and with interest accruing on the balance if the bill is not paid in full at the end of the month. Business credit can be useful for financing everyday or short-term expenses, especially in the case where the credit card includes a reward program for the business.
Invoice financing and invoice factoring allow a business to access capital using unpaid invoices. Invoice financing is a process of borrowing against a business's outstanding invoice; whereas invoice factoring refers to selling invoices to a factoring company at a discount. Despite some differences, both are considered debt funding methods well-suited for business-to-business companies with cash flow issues due to unpaid customer invoices.
A merchant cash advance offers a company a lump sum of capital that is repaid using a percentage of debit and credit card sales with an attached fee. The merchant cash advance company typically deducts from the borrowing company's daily or weekly percentage of sales until the advance is repaid in full. These can be useful for covering cash flow gaps and short-term expenses but are one of the most expensive forms of debt funding with annual percentage rates capable of reaching as high as 350 percent. Because of this, merchant cash advances are mainly treated as a last-resort debt funding option.
Mezzanine financing is a hybrid of debt funding and equity funding to form an agile alternative to both, using equity for business collateral to allow for higher levels of capital received by the borrowing company when compared to solely debt lending, while allowing a borrowing company to retain more company control than equity financing.
Similar to mezzanine debt funding, convertible debt is a type of funding in which a lender or investor enters into an agreement with the borrower or borrowing company with the intent to repay all or part of a loan by converting it into a certain number of preferred or common shares at a future point. The agreement specifies repayment and conversion terms, including the time frame for the loan, the price per share for the conversion, and the interest rate to be paid on repayment of the loan either until the time of conversion or until the loan reaches maturity.
Mezzanine debt and convertible debt are often compared because of their similarities. They are differentiated in the interest and equity dilution that occur in the deal. Convertible debt tends to include lower interest rates and a higher (or more expensive) equity dilution; whereas mezzanine debt has higher interest rates but lower equity participation.
There are several advantages and disadvantages of debt funding, such as allowing a business to leverage a small amount of money into a larger sum or enabling growth faster than might otherwise be possible, all while being a tax deductible debt that allows current owners to maintain control of their company.
Companies frequently choose debt funding over equity financing in order to preserve company ownership. In equity financing, a company can sell common and preferred shares, where the investor gains shareholder voting rights, and business owners dilute their ownership. Debt funding is provided by a lender who is only entitled to the repayment of the principal of the loan plus interest. Therefore, debt funding allows the business owners to retain ownership rights, and once the debt funding is paid back, the company and lender end their obligations to each other.
Another benefit of debt funding is the interest payments made on the principal are tax-deductible and can therefore decrease a company's tax obligations. Further, the principal payment and interest expense are fixed and known, assuming the loan is paid back at a constant rate and is a long-term loan, which allows a company to accurately forecast and makes budgeting and financial planning easier for the borrower.
It is also possible for a business to use debt funding instruments, especially when using an SBA loan, which typically has low interest rates. The SBA loan specifically includes a long repayment period with low rates, and, because of this, is often thought of as the gold standard for low-cost funding. Other debt-funding instruments can also offer competitive interest rates to attract businesses to their debt-funding products.
Similar to an individual building a credit history for themselves, one of the primary reasons a business may decide to take out a loan is to build business credit, which can be used when seeking out a low-cost, long-term debt funding instrument. Building business credit, especially for small- or medium-sized businesses, can help the business gain funding without relying on the founders' or owners' personal credit. And good business credit can help the business establish favorable terms with vendors.
Debt funding, especially long-term debt funding instruments, can help a business open new store locations, buy inventory, buy equipment, hire new workers, and increase marketing budgets. This can help a company run smoothly and profitably, all while maintaining control of the business. And debt funding can help the business grow and generate additional profits that the business may be unable to do otherwise based on its cash flow.
For companies that already use short-term debt funding options—such as lines of credit, credit cards, or short-term cash advances—long-term debt can provide a lower-interest, more stabilizing debt instrument that can pull a company out of short-term debt cycles. A long-term debt funding option may not be right for every business, but they usually offer lower interest than short-term debt funding options, and for a business experiencing a period of poor revenue, the long-term debt funding can reduce payments on debt, essentially reducing the cost of capital and increasing business cash flow.
Debt refinancing can be useful for a business with an existing debt load so it can renegotiate the terms to make them more favorable. Debt refinancing includes a business taking a new loan to repay existing debt, which can allow the business to update its lending agreement to something more beneficial to the business and even allows the business to improve its credit score at the same time.
While there are several advantages of debt funding (noted above), there remain several disadvantages to debt funding that, based on the purpose of raising the money and the goals of the business beyond the initial raise of the money, may make debt funding less attractive or not appropriate for those purposes and goals. Some disadvantages can include the interest and principal, which have to be paid back to lenders, regardless of business revenue, or even the lifespan of the business.
As noted, in the case of debt funding, a business is required to repay the lender. The rules are clear, with the terms of the loan agreed upon in order for the debt funding to be serviced. The business, and by extension the owners of the business, have to pay back the loan. Even in cases where a business goes under, those business owners have to make payments on the loan. And as most lenders require businesses and their owners to guarantee the loan, assets can be sold to satisfy the debt.
Depending on the lender, the eligibility requirements will vary widely, but lenders often require the business to have a strong credit history, meet a revenue threshold, and be operational for a minimum number of years. This can make debt funding harder to find for newer businesses or business owners, but for a business with a longer history or business owners with longer histories, finding debt funding can become easier. It can also be important for the business owner to best understand the requirements of a debt instrument to ensure they do not apply for capital for which they do not meet the requirements.
While noted debt funding can offer businesses low interest rates, these instruments can also come with high interest rates. Predatory lending can be an attractive option, particularly for newer or cash-strapped businesses in need of a quick injection, but these can include incredibly high interest rates and use methods other than APR to lull the borrower into a sense of security. Similarly, lines of credit or business credit cards can come with high interest rates for businesses with a poor or non-existent credit history. And businesses that sign up for debt funding with variable rates can see a dramatic change in repayment terms over time.
While noted above that taking debt funding can help a business build a credit rating, taking too many debt funding instruments can cause a business's credit rating to drop. More checks on the business's credit rating lead to a rating drop, and of course if a business struggles to make payments or make timely payments on the debt instrument, the business's credit rating will take a hit.
When a business takes out a loan or seeks debt funding, there will be a need for collateral as an additional form of security for the lender and to assure the lender that the borrower has a second source of loan repayment. Collateral tends to include any asset that can be sold by a bank for cash, such as equipment, buildings, and inventory (although that depends on the inventory). The amount of collateral required tends to be related to the size of the loan, and this is typically seen as a negative by some borrowers.
Any kind of debt can introduce strain on a business, and debt can make it difficult to manage a business's finance, especially as the payments are consistently expected, regardless of the business's revenue. This can cause stress on seasonal businesses or those with inconsistent cash flows. Some businesses can also find it challenging to try and grow operations while managing and repaying debt.
Venture debt funding is sometimes distinguished from regular debt funding as it tends to target early-stage companies looking to raise capital without giving up equity and without a proven track record for the business. Unlike traditional debt, venture debt is typically offered by specialized lenders—often venture capital firms, venture capital funds, and angel investors—who are willing to take on higher levels of risk for the potential of a higher return. Often venture debt funding is used as a complement to equity financing, although in some cases, a firm may offer venture debt funding for the chance at equity funding later down the company's growth through convertible debt and mezzanine debt funding.
Venture debt is frequently provided in the form of a loan and is used for a variety of purposes similar to those used by traditional debt funding. These can include financing research and development activities, acquiring equipment, and expanding a company. A venture debt lender can also provide additional support to the borrowing company, such as operational or strategic advice, and depending on the relationship between lender and borrower, can help the company achieve its goals. Unlike equity financing, venture debt does not typically involve giving up ownership in the company (although, as noted above, it can include some equity), nor should it dilute existing shareholder equity. However, venture debt tends to come with a higher interest rate and shorter repayment time than other debt funding instruments.
Similarly, venture debt can be considered to be a supplement to equity financing, helping a company raise extra capital, or act as a "sweetener" with amounts usually no more than 20 to 30 percent of the amount of the company's most recent equity round. The high interest rate and short maturity—with these types of debt often maturing in twelve to twenty-four months—tend to be intended for high-impact projects or business operations that require short, quick injections of capital to succeed, and which may otherwise be out of reach based on the business's operations and revenues.
