Business Loans

What Is Debt Financing?

Oct 08, 2021 • 10 min read
Debt financing vs equity financing
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      You may have heard the terms “debt financing” and “equity financing” tossed around, but do you know what they mean? For a small business, debt financing is the process of borrowing money by taking on debt—usually in the form of short term loans or business credit cards. When you pay off the debt, your relationship with the institution or individual that loaned you the funds ends. Lenders benefit from debt financing by earning interest on the money they allow your small business to borrow, while you, the business owner, benefit from having access to the funds.

      In equity financing, you actually trade ownership in your company for cash. Think of this as selling stock or shares in your company. An investor may buy a share of your company, which gets you the financing you need, but depending on your agreement, it may also mean the investor gets to have a say in how you run your business.

      Debt financing is the process of borrowing money by taking on debt—usually in the form of short term loans or business credit cards. Equity financing involves trading a portion of your ownership in your business for money, a.k.a., selling shares.

      What Is Debt?

      With debt financing, your creditors don’t buy into your company—they simply let you borrow their money usually for a specified period of time. You make the decisions regarding how you’ll spend the money. You also keep all future profits for yourself after you pay off your debt: there’s no long-term buy-in. What sometimes holds business owners back from debt financing is the negative connotation of the word “debt,” even though there are times when debt can be healthy and beneficial to your business. 

      Good debt” refers to debt associated with items or activities that can grow your wealth over time. A mortgage, for example, is considered good debt because the building you buy will likely grow in value. If you sell your property for a profit, which means you used the debt financing to increase your wealth. 

      A small business loan or other type of financing can also be considered good debt. You may take out an equipment loan to buy a machine to help you increase your company’s production of widgets. The more widgets you make, the more widgets your business can sell and the higher your business’s income. In other words, that equipment loan helped you earn more money, which is good. The same can hold true for financing that helps you hire a key employee, remodel, acquire more inventory, or open a new branch, among other things.

      Types of Debt Financing

      You can pursue different debt financing options depending on your current financial situation. The best option for you, however, depends on your payment preferences, the amount of money you need, and the current state of your business. (Companies with better credit might view some forms of financing as more affordable because they’ll receive lower interest rates). Get to know a few common forms of debt financing and how they can help your business. 

      • Short Term Loans
        Short term loans are provided by banks and other lenders. They typically have a repayment period of only a few years (or even one year for smaller loans). Businesses take out short term loans when they need to cover immediate costs (like the replacement of an HVAC system) that can get paid back quickly. Short term loans present less risk to financial institutions because they have smaller amounts and shorter payment windows. This can help small business owners save money when looking for debt financing.  
      • SBA Loans
        SBA loans are partially guaranteed by the Small Business Administration, part of the federal government. The role of the SBA is to boost commerce in the United States and support entrepreneurs and small business owners by working with lenders to provide loans. These loans can range in size—from microloans to large funding requests—and can have favorable terms.  
      • Equipment Financing
        Equipment financing is a very specific type of loan. You’re meant to use this debt financing option to improve your equipment. For example, a nightclub could invest in a new sound system, while a restaurant could invest in a catering van. Equipment financing loans are made for small business owners and may be a viable option if you’re still building up your business credit history. 
      • Business Credit Cards
        Business credit cards work just like personal credit cards. This is a form of rolling debt financing—instead of receiving a lump sum, you receive a credit amount and can spend as much as you want under that limit. As you pay off your business credit card, you can keep spending on it, covering your day-to-day business expenses. Business credit cards also come with rewards options similar to personal cards. You can save money by paying off your card regularly and taking advantage of cashback or travel rewards programs. 

      Business Lines of Credit
      Like a credit card, a business line of credit allows you to draw funds over time and pay back what you owe when you can. As long as you don’t reach your credit limit, you can keep taking out money to run your business. When you pay back your account, your credit is restored.

      Drawbacks of Debt Financing 

      While there are many benefits of choosing debt financing over equity financing, there are some drawbacks, too. The main one is the price: while debt financing allows you to retain ownership in your business, you will have to pay for the financing through interest rates, and different types of small business loans and financing may have higher interest rates. This is why it’s a good idea to shop around for debt financing. Work with a marketplace like Lendio where you may be presented with multiple financing options. And talk to your funding manager who can help you sort through the options to determine which one is really the best for your business and situation.

      Can You Grow Your Business with Debt Financing?

      Debt gets a bad rap sometimes. It’s often seen through the lens of personal finances, like a car loan that may get the borrower a functional set of wheels (or even a luxury sports car) but isn’t intended to make money. But business debt can work differently, particularly when it’s used to help spur growth.

      How does debt help a business grow? Say your business borrows money to build a sales team, expand into a new market, or establish an R&D division. In this case, the debt is seen as strategic as it aligns with the business’s plans to grow a new revenue stream. Like the auto loan, it’s still a matter of taking on debt, but this time the debt is enlisted for the business’s growth potential.

      Borrowing Money to Make Money

      Debt financing is simply the process of borrowing money to take on debt. Usually debt financing takes the form of a small business loan or a line of credit. While the dream situation for most small business owners is to use company-generated profits to drive future growth, depending on the stage of business or the breadth of the potential expansion, that may not be a practical goal. That’s where debt financing comes in. 

      “Simply keeping a healthy expense account isn’t enough to retain an edge,” says Thomas Mello, a small business owner who used debt to grow his firm. By avoiding debt, notes Mello, “you may miss opportunities that require a financial investment [while] your rivals race ahead growing their slice of market share.” Or, as Wayne Gretzky said, “You miss 100% of the shots you don’t take.”

      Make a Debt Financing Plan

      “Typically, when a business obtains debt or another type of financing, it’s for a specific purpose,” says Brian J. Sharkey, director of Audit and Accounting at Kreischer Miller. While growth alone seems like an admirable goal, it’s not enough to determine the potential for the debt. In other words, you need to start with specifics and a plan.

      Before you apply for financing, consider what’s required to achieve your goal. Will you need new equipment, new facilities, or a bigger team? Will adding a new tech tool or software improve productivity for your sales department so they can close more deals? If the debt you’ll take on doesn’t directly support an income-producing initiative, it probably can’t be categorized as “helping you grow.” 

      Additionally, consider your expected return for expanding your operations. When you put the numbers to paper, does your estimated return justify the expense? “Most companies will have a plan for what they are trying to accomplish,” says Sharkey. “But many fail to quantify the anticipated return.”

      See the Long-Term Picture

      By having a clear idea of how you’ll use the borrowed funding, you’ll also be able to get a better view of how long it will take before the money borrowed starts to show a return. In general, you don’t want to take out long-term financing for a short-term return. In other words, if you’re going to be paying back the loan for years, you want to make sure your ROI spans years, too.

      “A good way to look at this is to line up leverage with the assets you’re acquiring so the debt service period matches the time period you expect to receive returns from the asset,” Sharkey suggests. You may find that for a short-term expense or a one-time return, a business credit card is a better solution.

      Find the Right Debt Financing Leader

      There are a lot of financing options available and each comes with different terms. While your goal should be to consider as many offers as possible, it’s often easiest to work with a marketplace like Lendio, which offers a simple application process and helps businesses find the right financing for their specific situation. Additionally, you’ll work with a funding manager who can help you sort through financing options available for your business so you can easily narrow down the options. That way, you’re using the right debt for your growth goals, budget, and business.

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      About the author

      Lendio's team of experts is here to help you with every nook and cranny of your business. We'll make sure you have the best advice for financing, operations, management, hiring, and much more.

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