The end game of every business is to grow, generate more revenue, and rack up profits – it doesn’t matter if it’s a startup or a behemoth like Walmart. At specific stages of a business, funds would be required in furtherance of this goal, whether it’s to invest in a new line of product, buy out a competitor, or even expand its operations. If you’re a startup, you’ll probably borrow money from family and friends, or seek funds from angel investors. Big corporations, on the other hand, either reinvest their profit or secure funds from external sources.
In this post, we’re going to explore one of the most common means companies use to raise capital – Debt financing.
Definition
Debt financing occurs when a company raises money for working capital (or capital expenditures) by selling debt instruments to individuals and/or institutional investors. In return for the lender’s money, the company agrees to pay the principal with a predetermined interest after an agreed-upon period.
Debt instruments can be thought of as a slightly sophisticated form of ‘I Owe You’ (IOU). Some of the common types of debt securities companies use include:
- Bonds: Junk bonds, Eurobonds, high yield bonds, and more – they usually have a maturity of, at least, one year.
- Medium-term notes: They typically have a maturity of up to 30 years.
- Commercial paper: similarly to bonds but have a maturity date of less than one year.
In addition to debt securities, companies also use bank loans to raise funds. There are many types of bank loans, such as:
- Term loans: which is a loan for a specific amount with an agreed repayment schedule and whether a fixed or floating interest rate.
- Overdraft: An overdraft allows you to go below zero in your bank account. For instance, with an agreed overdraft of $6,000, your account balance can go down to -$6,000.
- Revolving facility: This is a form of credit issued by a financial institution that provides the borrower with the ability to draw down or withdraw, repay, and withdraw again, in any manner, and any number of times until the revolving facility expires.
How Debt Financing Works
Companies obtain external finance through three main routes: equity, debt, or the hybrid of the two. With equity, the company sells out ownership in the company. Consequently, the buyers (investors) become part owners of the company, and they receive dividends.
On the other hand, with debt, no ownership is lost. Instead, the company pays back the principal plus interest to the lenders after a specified period. For instance, a company seeking to raise capital through debt can issue a bond. Investors that purchase the bond are lenders that provide the company with debt financing.
The debt they provide can either be secured or unsecured. For secured debts, the assets of the company are used as collateral for the loan. If the business goes bankrupt, the lenders can liquidate the assets to recoup their investments. Unsecured debts, on the other hand, are not tied to any collateral. However, if the business goes bankrupt, the company is still under the obligation to pay back the lender.
The key distinction between debt and equity is that with equity, the company loses part of its ownership to the investors. If the venture eventually becomes unsuccessful, the company is under no legal obligation to pay equity holders.
Pros of Debt Financing
Here are some of the benefits of debt financing:
- Maintaining Ownership
As we’ve identified before, unlike equity financing, debt financing gives you complete control over the business. This frees you from the hovering attentiveness and influence of investors.
- Tax Deduction
Unlike private loans, another perk of debt financing is that interest fees are tax-deductible, making it a good way to lower taxes.
- Retaining Profits
Under equity financing, you have to pay investors dividends, based on the amount of profit you make. Under debt financing, after you’ve paid the principal and agreed-upon interest, any extra money you make is entirely yours to keep.
Cons of Debt Financing
- Accessibility
Banks are typically wary of lending money, particularly to small businesses. Consequently, while big corporations have easier access to debt financing, new businesses tend to struggle to secure one.
- Repayments
Whether the venture eventually fails or succeeds, you are still obliged to repay your debts. Make sure your business can generate enough cash to service the debt before you opt for debt financing.
- Credit Rating
Failing to make the scheduled payments on time will hurt your credit score, making it more difficult to secure future loans.
- Cash Flow
Making regular repayments detracts from the cash flow until complete repayment is made. This can be particularly challenging for startups with limited cash.
- Bankruptcy
Securing debt finance puts you at the potential risk of bankruptcy. If for whatever reason you’re unable to make repayments, your lenders have the right to liquidate your assets, especially if the loan you took was secured.
Wrap Up
Debt financing offers a great way for companies to raise capital without parting with equity. However, it comes with greater risk, especially if the company can no longer service its debts.
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