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Updated: November 20th, 2023
Only 0.07% of businesses receive VC funding, a highly publicized form of equity financing. So, how do the other 99.93% of businesses obtain the capital they need to grow? According to data from the U.S. Small Business Administration (SBA), small business owners borrowed an estimated $1 trillion in 2013 — $585 billion in business loans outstanding, $422 billion in credit from financial institutions, and the rest from a mix of sources. This makes debt among the most popular forms of financing; however, accessibility is just one of the many advantages of debt financing.
Keep in mind that there are several forms of debt financing, including lines of credit, small business credit cards, merchant cash advances, and term loans. Make sure to explore all of your options for debt financing and select the one that best matches the unique needs of your project. While a term loan is appropriate for long-term growth investments, such as hiring more full-time employees or opening a new office or retail space, a line of credit is best suited for businesses looking to cover expenses that can be repaid within 12 months.
Whether you choose a term loan or line of credit, debt financing offers several benefits. From maintaining control of your company to receiving tax breaks, let’s review the six advantages of debt financing.
Debt financing is a method that businesses and individuals use to raise capital by borrowing money from lenders or investors. It involves obtaining funds through the issuance of debt instruments such as loans, bonds, or promissory notes. In debt financing, the borrower agrees to repay the principal amount borrowed along with interest over a specified period.
Here are some key characteristics and components of debt financing:
Principal Amount: This is the initial sum borrowed by the debtor, which must be repaid to the lender.
Interest: Lenders charge interest on the principal amount as compensation for lending their money. The interest rate can be fixed (remains constant throughout the loan term) or variable (adjusted periodically based on an agreed-upon benchmark). This will be determined by a borrower’s credit history.
Term: Debt financing arrangements have a specified term or maturity date, which is the period within which the borrower must repay the debt in full. Terms can range from a few months to several decades, depending on the type of debt instrument.
Collateral: In some cases, lenders may require borrowers to provide collateral, which is an asset that can be seized and sold to recover the loan amount if the borrower defaults on payments. Common forms of collateral include real estate, vehicles, or business assets.
Amortization: In loans, particularly those with fixed interest rates, borrowers make regular payments that consist of both principal and interest. As time goes on, the portion of the payment allocated to interest decreases, while the portion applied to the principal increases.
Businesses commonly choose debt financing to fund various activities and projects, such as expansion, acquisitions, working capital needs, or capital expenditures. It can also be used by individuals for purposes like buying a home (mortgage), purchasing a car (auto loan), or funding education (student loans).
While debt financing provides access to capital, it also comes with obligations to repay the borrowed funds and the associated interest. Businesses and individuals should carefully consider their ability to meet these obligations and manage the overall debt burden to avoid financial difficulties or default. Additionally, the terms and conditions of debt financing arrangements can vary widely, so it’s essential to thoroughly review and understand the terms before entering into any debt agreement.
Business Debt Financing Let’s say a small manufacturing company, ABC Widgets Inc., wants to expand its production capacity. To do this, they decide to obtain debt financing through a business loan from a bank. Here’s how the process might work:
Let’s consider an individual named Sarah who wants to buy a home. She uses a mortgage to finance the purchase:
These examples illustrate how both businesses and individuals can use debt financing to achieve their goals, whether it’s expanding a business or purchasing a home. Debt financing provides access to capital that can be repaid over time, usually with interest, according to the terms of the loan agreement.
If you have followed the TV show Shark Tank, then you’re familiar with the haggling process after the business owner’s pitch, in which investors offer (and adjust their offers) for upfront capital in exchange for equity (check out a sample deal negotiation with inflatable pad manufacturer, Windcatcher).
While the Windcatcher owner was lucky enough to receive a deal with a lower equity stake than he was willing to give up, he still has to part ways with 5% ownership in his company. When seeking equity financing, other business owners may not be as lucky and have to give up a 10%, 15%, or even 20% stake in their company for an investor to be willing to fork out cash.
With debt financing, you don’t have to give out an ownership stake in your company. Under certain circumstances, you may have to use a piece of machinery, vehicle, or very liquid accounts receivable as collateral for a loan, but you only would have to give up ownership of that collateral if you were to default on the loan. Ownership of your company stays with you.
With company ownership comes control over management decisions. Depending on how much ownership you give up to third parties in exchange for equity financing, you’ll find yourself being less nimble to make decisions on your own. You often will have to seek approval for a mutually agreed list of items, ranging from hiring new personnel to selecting vendors. Virtually all equity investors seek some level of authority in the decision-making process of companies that they invest in.
On the other hand, a lender has no say in how you run your small business. They may still want to take a look at your financial statements to perform a cash flow analysis, but they won’t have to approve your purchases of supplies or hiring decisions. As long as you meet your scheduled payment plan on time, they’ll be happy to let you run your business as you wish.
Regardless of whether they’re charges from a term loan, line of credit or working capital account, any interest paid on money that you borrowed for business activities is tax deductible.
In Chapter 4 of Publication 535, the IRS indicates that you can “generally deduct as a business expense all interest you pay or accrue during the tax year on debts related to your trade or business” as long as the loan proceeds are used for business expenses and:
This deduction is available for all types of small businesses. Here are some examples:
Many types of charges from your lender for financing or refinancing a loan—including origination fees, maximum loan charges, discount points, or premium charges—can also help you lower your business tax liability. Certain limitations may apply, so consult IRS Publication 535 or contact your accountant for more details.
Due to the tax advantages of debt financing, you’ll need to adjust your interest rate when comparing debt financing to alternative financing options.
Let’s imagine that you were evaluating whether or not to take a loan with an interest rate of 14%. Assuming that your business tax rate was 25%, your after-tax interest rate is 10.5% (14% – (1 – 25%)). When bringing taxes into the picture, 10.5% would be the actual interest rate that you would need to use in forecasts about your business. This is one of those times in which taxes can actually help you improve your bottom line.
While there are alternative ways to raise funds, many of them aren’t accessible to small business owners. Here are two examples that speak to the advantages of debt financing.
First, in 2012, only 2% of small businesses listed venture capital as a source of funding, according to data from the U.S. SBA. On the other hand, 87% of small businesses listed debt financing as a source of funding. One key reason is that venture capitalists are looking for the next “unicorn” (companies with an estimated valuation north of $1 billion) and that disqualifies a majority of small businesses, even those with a positive cash flow history.
Second, while sole proprietorships aren’t prohibited from issuing bonds, very few can comply with the mandatory federal regulations and cover the associated expenses with the process of issuing bonds. If you think meeting the necessary requirements for an asset-based collateral loan can be hard, then complying with the more stringent collateral requirements for issuing bonds is virtually impossible.
On the other hand, even the smallest of small businesses can shop around for some form of debt financing.
Making timely payments to your lender of choice serves as a way to improve your personal and business credit score, another example of the advantages of debt financing.
It’s a great practice to separate your personal from your business finances, but it’s an even better one to separate your personal credit score from your business credit score. A great business credit score demonstrates to vendors and lenders alike that you are a responsible business owner and that your business’s cash flow is sufficient to meet its obligations. Even when a lender doesn’t report to a business credit bureau, having a financing contract and a record of payments may lead to better financing opportunities.
Being responsible with debt financing can help you boost the creditworthiness of your business. As your business credit score increases, so will your business credit offers. Having access to better debt financing can help you cover any future cash crunches more efficiently.
If you’re looking for business financing, you’ve come to the right place. Funding Circle provides fast and affordable small business financing. Contact us today for more information and to apply for financing! Grow your business confidently.
Louis DeNicola is the president of LD Money Media LLC and an experienced finance writer who specializes in credit, personal finance, and small business finance. Within the small business sphere, he helps business owners understand their financing options, cash flow management, business credit, and taxes. In addition to Funding Circle, you can find his work on BlueVine, Credit Karma, Experian, Wirecutter, and Lending Tree.