Debt financing means borrowing money from a lender such as a bank or a private investor, which you pay back with interest over time. Businesses turn to debt financing when they need to raise capital to finance operations, projects or business growth.
Whether you're setting up a new business or growing an existing one, you're likely going to have to raise some capital using either equity or debt finance. With equity finance, investors provide funding in return for shares in the company – they're taking a chance on the business becoming more successful. Debt financing means borrowing money from a lender such as a bank. You won't dilute the business ownership, but you will have to pay the money back with interest over time.
What Is Debt Financing?
Debt financing is, essentially, any type of loan. That loan could be secured by collateral as with a mortgage or it could be unsecured like a traditional revolving credit card account. Whatever form it takes, debt financing is always time-bound. This means you must repay the loan with interest by the end of an agreed period, either by monthly repayments or as a onetime balloon payment at the end of the loan term. An important feature of debt financing is that you are not giving up ownership in the company. This contrasts with equity financing, where the company raises cash by issuing stocks of shares.
What Are the Two Major Forms of Debt Financing?
The most common type of debt financing is a term loan from a bank. With a term loan, you borrow cash for a specific period and pay it back over time with interest. Interest rates vary by lender and are largely dependent on the company's financial history – if you have a weak trading record and unpredictable revenues, you won't qualify for the best rates.
Another type of debt financing is bond issues. A bond functions just like a bank loan, only the money comes from private investors, not the bank. The bond specifies the interest rate and the time when the loaned money must be returned. The advantage here is that you can choose your own interest rate, which typically will be lower than the rate you would be required to pay to obtain a bank loan.
Why Businesses Need Debt Financing
Businesses turn to debt financing when they need to raise capital to finance operations, projects or business growth, whether that's buying new equipment, fulfilling a high-value contract or launching a new marketing campaign. These types of projects typically require a large upfront investment, and debt financing helps spread the cost over time. One of the main advantages is that it allows you to keep control of your company. Unlike equity finance, debt finance has no effect on ownership or how the company is run. You do have to pay the loan or bond back, however, so it's more expensive than equity financing. You should always shop around for a funding solution that best meets your needs.
Debt Financing Downfalls to Watch Out For
For small businesses and startups, the biggest problem is getting a loan in the first place. Lenders look first at your cash flow, trading and credit history. They want to be sure that you can make regular payments and they usually want some form of collateral. A business owner might also have to provide a personal guarantee to repay any outstanding debt, potentially putting her own assets at risk. These criteria can be a tough call for early-stage businesses or those with uncertain cash flows. You're also at the mercy of interest rates. Even a small hike in rates could leave you overleveraged and unable to meet your operating expenses due to debt repayment obligations. Businesses that borrow money for revenue-generating activities, such as upgrading machinery or adding a product line, may be better able to offset the risk.