What Is Debt Financing?

In business, the only surety is that some things will not go as planned. Maybe some of your plans will go awry. Or perhaps an unexpected window of opportunity will open and you'll have the chance to grow rapidly. If there's a slow season, better (and more profitable) times might be ahead if you can keep making payments for the day-to-day operations and your business expenses.

In all of these scenarios, the one constant is that you need money to accomplish your goals. But what if you don't have the amount of money on hand to pull it off?

If your business needs an influx of capital now rather than later, there are a couple of options. Sure, equity investors may be willing to kick down your door to be first in line to offer equity financing. If you're loathe to sell away shares of your company, though, raising capital through debt financing may present a better option for your situation.

Understanding Debt Financing: Types of Income

Operating with debt is something most companies experience during their lifetime. Successful businesses use effective debt management to turn owing money into as much of an advantage as possible. Startups in need of working capital can find a form of debt financing that best suits their needs. Business credit can be hard to come by when your business plan meets the unexpected.

Debt funding, debt lending, or debt financing - the names differ, but the basic concept remains the same. You need a quick infusion of cash or credit for your company. The reasons can vary - filling in a cashflow gap between accounts payable and accounts receivable, expanding or updating your operation, or keeping everything afloat during a downturn - but the bottom line is getting the money you need.

Under a debt financing plan, your business receives the funds it needs in exchange for a promise to pay the amount back, with interest, in a set amount of time. If that sounds like a loan to you, well, you're not wrong. Let's see how it works and what types of loans are available.

Installment Loans

Installment loans are a simple way to get access to quick capital. Bank loans are common, but other sources are available as well. They're available from a variety of sources, including:

• Commercial banks and financial institutions
• Savings institutions
• Credit unions
• Finance companies
• Online lenders

The Small Business Administration (SBA) specializes in matching businesses that are looking for loans with vetted lenders. These business loans are backed by the SBA. You're likely to find plenty of debt financing options with SBA loans and can shop for low interest rates.

The advantages of debt financing are clear when opting for a loan. Your company can take a tax deduction for the interest payments. The monthly payments are on a repayment schedule, making it easier to know how much you need to allot each month. Perhaps the most important benefit is that you retain control of your company instead of selling off shares and potential future profit.

You should be aware of the disadvantages of debt financing. Loans aren't one-sided. Whether or not your business survives, you are still on the hook for repayment. Your credit rating will suffer if you don't meet your repayment terms. Assuming the debt of a loan can have a negative effect on your credit score, which will worsen your creditworthiness if you default.

Also, keep in mind that if things do end up falling apart, Chapter 11 bankruptcy isn't a cure-all. During business bankruptcy, for example, your business lenders and bondholders take priority when assets are allocated.

Revolving Loans

A revolving loan such as a line of credit offers flexibility and only charges interest on the outstanding debt. It stretches the definition of a loan, as there's no lump sump delivered. The higher interest rates can upset your balance sheets. Credit cards are also a possibility, but the interest rates that accompany overdue balances are often a financial backbreaker.

"Loans" Based on Cashflow and Debt Financing

There are other types of debt financing. These methods to generate quick income aren't quite loans. All offer advantages and disadvantages.

Invoice Financing

If you've got steady customers with a clean payment history, you can sell their outstanding invoices to a third party. You'll have to do so at a discount, but you'll get a smaller share immediately. Invoice financing doesn't fit the true definition of a loan, as you're selling your accounts receivable and don't owe additional interest.

Selling Bonds and Notes

A business owner can sell bonds and notes to raise immediate cash. Bonds are issued as long-term investments for the investor. They'll get the amount they lent back on the maturity date and receive interest payments until then. Notes are similar to bonds but vary more in maturity dates and payment terms. They can act as short-term loans.

Why Not Private Equity?

Opting for equity to fill short-term financial needs is tempting. There's neither debt nor interest to pay. You have no repayment obligations. Operating without debt can make your company seem more secure and keep your assets unencumbered.

Still, accepting equity is agreeing to have a new partner in your business, no matter how small their portion is. You'll no longer have full ownership. When profits start rolling in, you're required to give them their share. With capital raised through debt financing, your obligation ends once you've made your final payment.

Decisions, Decisions

There's no single correct answer when it comes to choosing how to raise business capital. Each company is different, as will be their situation. Given the flexibility of debt financing and the concrete end-of-debt terms it brings with it, it's worth consideration as a feasible option.

Related Resources:

• Ten Things to Think About: Financing Resources (Findlaw's Learn About the Law)
• Financing Basics (Findlaw's Learn About the Law)
• Sources of Small Business Financing (Findlaw's Learn About the Law)