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Debt Financing Options To Get Needed Capital For Your Business

by Amarachukwu
Debt Financing Options To Get Needed Capital For Your Business

Getting the necessary fund to finance your business can prove to be a herculean task. Since time immemorial, investors in startups have had to brainstorm on raising the capital that they need to start and sustain their business.

While richer investors and businesses that have been established for a longer period enjoy the luxury of getting financial support through traditional bank loans, stakeholders in small and medium scale enterprises alongside their businesses have to rely on alternative sources of debt financing.

There have been complaints that traditional financial institutions and lenders have paid less priority to small and medium-scale businesses, and are not willing to offer financial assistance to the same since the 2008 financial crisis. They also allegedly tend to favor bigger and more established businesses with sufficient collateral, consistent cash flow history as well as a favorable debt-to-income ratio.

Debt Financing Options to Get Needed Capital for your Business

As a result, small and medium-scale businesses with a short operation history or those that are long-established, but with a poor credit history have struggled to secure a bank loan to run their affairs. As if that is not unfortunate enough, the more often rejection their application for loans face, the more difficult it becomes for them to get another loan approved from the same institution.

Small and medium-sized companies have therefore settled for alternative sources of financing debts. Some even prefer these alternative sources to traditional financial institutions due to the relative flexibility of their processes amongst other factors. This flexibility ultimately makes it easier for applicants to secure the needed fund.

According to the 2019 Small Business Profile, small and medium-scale enterprises (SMEs) were over 30million and makeup to over 90% of all businesses in the United States. These small and medium-sized businesses are also responsible for the employment of about 59.9 million Americans. This is about 50% of the entire American workforce. Therefore, the importance of SMEs to the American economy cannot be overlooked.

Debt financing, also known as financial leverage, occurs when a business raises funds through the sale of debt instruments like bills, bonds or notes to interested investors. The funds generated from debt financing are always paid back. This is unlike in equity financing where lenders get stock.

Simply put, debt financing is said to have taken place when an organization borrows money meant to be paid back with interest on an agreed future date. Depending on the loan terms, it could be secured or unsecured. It could be used to finance an acquisition or a working capital. 

1.       Non-Bank Cash flow lending

Lenders can approve your loan application by analyzing factors like your assets, credit, and investment history as well as profits. This is a risk-minimizing technique employed by lenders to tell of your ability to pay back.

Other factors like the frequency of your transactions, expenses, online and other verifiable reviews, and customer return rates amongst others may be reviewed.

Debt Financing Options To Get Needed Capital For Your Business

Depending on the agreed terms & conditions, these loans could be repaid at a percentage of sales recorded by the business over an agreed period until it is completely paid off.  

Cash flow loans are considered to be high-risk loans and as a result, some lenders charge hidden fees or give the loan at higher interest rates.

 

2.       Software as a Service (SaaS) credit

The Software as a Service credit also known as the Recurring Revenue Lending is a system where companies are given loans to reflect their monthly recurring revenue (MRR).  In this option of financing, the company’s customer subscription per month determines the amount for the said month.

It is a great alternative for businesses that can prove a robust customer retention culture. Businesses with a few assets but have annual revenue growth of over 20% may want to consider this option.

To determine eligibility, lenders audit the business’ historic and recent income streams. Although the requirements are not static, most borrowers are obliged to maintain at least a renewal rate of 75% or more to be termed as qualified.

 

3.       Financial Institutions’ loans

Despite how difficult it has been for small and medium-sized businesses to secure loans from banks and other traditional financial institutions, one cannot but include them as they are one of the most common fund providers.

Businesses that are serious about getting funds from the bank must prove beyond reasonable doubt that they are an entity that should be taken seriously. They must follow the strict requirements, present a convincing credit history as well as a long-term investment history. When you have a proven track record of success, there is every likelihood to get funding from the bank.

 

4.       Loan from Family member(s) or Friend(s)

A lot of businesses got their feet off the ground through handouts from family members and friends that believe in the dream of the businesses’ owners/stakeholders. The loan may come in bulk or in bits.

For some start-ups, their first earnings were from close friends and relatives. This is before spreading their tentacles and they start to record significant growths.

Most loans from family and friends are characterized by little or no interest rates, minimal documentation, and almost immediate access to the required funds.

As easy as it seems to secure loans from family and friends compared to the bank, high reputational risk is involved and relationships are at stake.

Before approaching a family member for a loan, you must evaluate your ability to pay back, even in the case of bankruptcy. Also, do your folks fully understand the financial risk involved in investing in your business, trusting you with their hard-earned money?

To prevent a situation where sweet relationships turn sour over money, you may want to try the family and friend loan option with a detailed repayment plan and a clear understanding of what is about to happen. Close relatives and friends have become sworn enemies over a loan gone bad. This is avoidable.

Debt Financing Options to Get Needed Capital for your Business

5.       P2P Lending

The Peer-to-Peer (P2P) lending option is another reliable option to raise funds. Start-up founders who don’t mind having the details of their business and finance in public have this lending option at their disposal.

It is a lending option where borrowers are matched with lenders by an online lending company after the repayment terms are mutually understood. For the individual lender or investor, it is an avenue to earn cash passively as the borrower does not just pay back the principal amount, but with interest.

Unfortunately, most P2P lending companies do not offer the luxury of professional advice and guidance that is normal in established institutions.

 

6.       Home equity loans

This alternative is available to borrowers that have real estate equity and a good credit score. This form of loan is a one-time financial infusion into your business and you are expected to repay at a fixed monthly rate, just like a mortgage.

The interest rates of home equity loans are always lower when compared to standard bank rates. On average, the interest rate for home equity loans is 6% as against that of bank loans that average between 8 and 10%.

Since company assets are at risk as collateral, borrowers are advised to be sure of their ability to pay off the loan so as not to risk losing their collateral.

 

7.       Credit cards

Disciplined business owners and stakeholders have successfully built their humble start-up into a household name as well as built trust with lending institutions with the use of credit cards.

Some entrepreneurs have taken advantage of juicy offers on credit cards like 0% APR in the first year to provide the necessary financial support that their small businesses require.

On the negative side, credit cards attract high-interest rates for late repayment and cash advances.

 

8.       Partner Financing

Much is not usually said about this option of financing your business ideas, but it is a good way out of your business’ financial incapacities.

Strategic partner financing a bigger player in the industry (usually a bigger and more experienced company) partners with you and funds some aspects of the project. The fund then grants the company access to your product/service, staff members, sale & distribution as well as other aspects of the venture as agreed by both parties.

Partner financing could be royalty-based where the said partner is entitled to an agreed percentage on every sale made.

The partnership can also be an avenue to tap from the partner company’s wealth of experience since they are usually more experienced.

 

9.       Crowdfunding

The crowdfunding alternative has been used to secure tuition fees and hospital bills, just as it has been used to fund start-ups too. This option gives businesses the opportunity of pooling funds in bits from multiple investors. The small amounts may not be much from the investor’s point, but those little funds can translate to something huge when gathered together.

Many start-up founders have been able to raise significant amounts as their seed funds for their businesses through online platforms before going ahead to pitch their ideas to investors. However, you must note that some crowdfunding sites require that you pay a processing fee. Some also expect that you hit your full financial goal in order to be able to the money that you raised. So, watch out for these terms.

 

10.   Grants

Businesses that focus on science or research stand the chance of getting grants from the government. They are sometimes called research grants.

For example, the United States Small Business Administration (SBA) is known to offer grants to small businesses via the program known as the Small Business Innovation Research and Small Business Technology Transfer programs.

Qualified business owners apply for these grants and convince the designated authority on why it should fund their projects and the benefit of the same to their immediate community and the nation at large.

Debt Financing Options To Get Needed Capital For Your Business

Advantages of debt financing

1.       It preserves company ownership

This is probably the main reason companies opt for the debt financing option. This option is unlike in the case of equity financing like selling common and preferred shares, where investors hold unto equity position(s) in the company, and they gain voting rights as shareholders, making the original owners of the company dilute their ownership structure.

Since debt financing is a loaned capital to the business, the same is only expected to pay back the capital and the agreed interest to the lender. As a result, the business owners/stakeholders retain 100% of the company’s ownership and end the relationship with the lenders the moment the debt is completely paid off.

 

2.       Interest payments are tax-deductible

Another advantage of settling for the debt financing option is the fact that the interests paid on the loan are tax-deductible. This means that it reduces the business’ tax obligations. Also, when the loan is refunded at a constant rate, the principal and interest are fixed and known.

This makes forecasting more accurate and eases the company’s budgeting and financial planning process: 

Disadvantages of Debt Financing

1.       Requires regular income

For a business not to be guilty of repayment default, it needs to be able to boast of regular income. The regular refund of the principal and interests in installments may become a challenge for businesses that struggle with earning as regularly as possible.

This tops the reason why some lenders insist on the company’s assets as collateral for the loan. The company also risks having its assets seized upon failing to pay the agreed amount as at when due.

2.       May negatively affect credit ratings

If the borrower skips a payment or is paid late, this will affect their credit ratings negatively. And it is no news that poor credit ratings make it more difficult to borrow money in the future.

3.       Potential bankruptcy

When a company submits its asset as collateral for a loan, it risks losing its asset if for any reason it defaults. Also, should the company crumble, it will still pay up the debts it is owing, thereby, risking possible bankruptcy.

 

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