When you make debt financing a part of your business development plan, you’re raising money for capital expenditures or working capital by selling some debt instruments to institutional investors and/or individuals. There’s an exchange that occurs here.
In return for the money they’ve lent you, these institutions and/or individuals will become creditors, with the promise that you’ll repay them the principal as well as the interest that has built up over time on the debt.
The types of businesses that are best suited for debt financing are high-growth businesses, as they’ll be able to generate a large amount of cash flow, making it possible for them to pay back their debts.
The pros of debt financing include management control being retained, the interest payment being tax-deductible, accessibility, a lower interest rate than with traditional loans, and the acceptance of a business credit score.
They also include no profit-sharing. However, there are cons, too.
These include your credit rating being affected, a lower cash flow because of your debt, the need to put up collateral much of the time, and having to repay the debt plus interest.
Venture debt is a debt financing type usually obtained by startups and early-stage companies. Usually, this financing is used as an alternative to equity venture financing. These loans are available both through traditional banks and non-traditional lenders.
Something that makes this financing different from other types of debt financing is that you aren’t expected to provide collateral. Instead, lenders will receive warrants on common equity.
Usually, you’ll be able to get this type of funding if you’ve already been successful several times around with venture capital equity fundraising.
This type of debt is usually repaid in a short amount of time, up to three years after it has been lent (and sometimes four). Interest rates make up a large part of repayment, and can sometimes be as high as 20%.
The idea is that the warrants will, in the future, be converted into the startup’s common shares.
Business loans are another form of debt financing. These include microloans, online loans, bank loans, and small business loans. Microloans are issued, instead of by a credit union or bank, by an individual or a group of individuals.
When you get this type of loan, you’ll be expected to pay back the debt as well as interest. Because these are non-traditional and riskier loans, the interest is usually higher than with traditional loans.
Online loans are loans you get online, with some fully online banks offering lower interest rates than traditional lenders.
Bank loans are the most traditional type of loan you can get, where you’ll pay off the debt with traditional interest.
Small business loans are incredibly beneficial, as these are designed with small businesses in mind.
These include working capital loans, accounts receivable financing, small business term loans, equipment loans, and SBA small business loans.
Another type of debt financing is credit, which includes using credit cards and a line of credit. If you don’t have much capital and aren’t able to find lenders, using a credit card can be a good way to go. This is a great choice if:
- You get rewards when using the card
- The card has a reasonable interest rate
- Your credit limit is high
It’s a great choice if your startup is new so you don’t have any business credit yet—but you still have good personal credit. According to the SBA, this is a common way that many small businesses have funded their businesses in the past.
Another choice is using a line of credit, which your bank can offer you. As long as you don’t go over the maximum amount, you can draw money from your account whenever you need to.
Another type of business financing is equity financing. When you use this funding method, you’re selling your shares in exchange for capital. When you do this, you’re selling ownership of your company in exchange for the cash you need.
Equity financing is a good choice for startups that need cash in the short term.
It’s also used by companies that are in the process of growing but haven’t reached maturity yet. When these companies do this, they’ll usually go through this type of financing several times.
One of the biggest pros of equity financing is that you don’t have the burden of debt. You won’t have to repay a loan or interest, so you can focus on the growth of your business as it becomes more successful.
Other pros include no issues with having good or bad credit to get the money you need—and the benefits you get from having additional partners.
However, there are cons. You’ll have to share your profit with these new partners. Additionally, you’ll have to share control. This can cause potential conflict.
One of these types of investments is personal investment. This is when an individual provides you with money in exchange for your startup’s shares. For example, if you have a potential financial investor who could also be a good partner, this might be a way to go.
Keep in mind that, when this happens, you’re yielding some of your company’s control to this individual.
For this reason, you may want to put together a contract explaining which responsibility is whose in the running of your business.
Friends and Family
Your friends and family might also be able to help you invest through equity financing. One of the benefits of this type of financing is that your friends and family are emotionally invested in the success of your business.
However, it can also make these relationships complicated. The last thing you want is a friendship ruined by a friend suddenly wanting to take over control of your business.
Family can be a bit more reliable, especially when it comes to being able to provide you with a larger amount of money.
However, if your family relationships are affected by this business partnership, it might make things complicated.
When getting equity financing from friends or family, it’s a good idea to provide boundaries and even potentially put together a contract about working together.
Business incubators are organizations that provide resources and support to early-stage businesses and startups that they would otherwise have difficulty accessing. In addition to potential investors, you’ll also get access to:
- Networking opportunities
- A coworking space
- Reduced rates for industry professionals (lawyers, for example)
- Workshops with advisers and mentors
In exchange for all this, a business incubator will ask for a return on their investment in the form of equity stakes. Keep in mind that business incubators will have an application process you need to go through, which can be quite competitive.
Business incubators are often run by non-profit organizations, academic organizations and universities, Venture Capital firms, and commercial organizations.
If you’re searching for the support of a business incubator, find one that specializes in businesses much like your own.
Small Business Grants
When you receive a small business grant, it’s financial support for your business that you don’t have to pay back. There are many types of small business grants, which you can get from county, state, and federal governments.
Additionally, small business grants are sometimes available through local organizations or private businesses.
Often, you can use small business grants to cover other forms of financing we’ve covered in this article, such as lines of credit, microloans, or loans.
Usually, support will come through an organization that wants to support a specific type of business. For example, you might be able to get a grant from an organization that supports businesses founded by female entrepreneurs.
There are many grants out there, but they have different requirements. For this reason, you should do your research to find out which grants your business can benefit from most.
When you use the crowdfunding financing method, you’re getting small capital amounts from a large group of people. Usually, social media is used to bring attention to your crowdfunding campaign, where entrepreneurs and investors can invest in your business.
This expands your investor pool far past the traditional limits of venture capitalists, relatives, and owners.
Crowdfunding is usually done through a crowdfunding website. Those most often used include GoFundMe, Kickstarter, and IndieGoGo.
The biggest advantage of crowdfunding is how many different investors you can potentially reach when running your campaign.
You’ll also be interacting directly with consumers and learning about the potential popularity of your business offering.
However, you might not be able to keep any of the money if you don’t reach your goal. You could also negatively impact your business’s reputation if the campaign doesn’t go well.
An angel investor, also known as an angel funder, seed investor, or private investor, is an individual with a high net worth who provides entrepreneurs or small startups with financial backing. Usually, they do this in exchange for some of the company’s ownership equity.
This investment might be a one-time payment made at the beginning of the business’s life. Sometimes, it might be money provided to the business in a more ongoing manner, so that it continues to get support over time.
Angel investors tend to be good for business, as they’re more focused on helping a business start out than focusing on profit.
Usually, angel investors will use their own money to fund your business. However, the entity providing the funds might be an investment fund or trust, a business, or an LLC.
Private Equity and Venture Capital
Even though private equity and venture capital are often seen as the same thing, they aren’t. While both of these invest in businesses and then make money after selling their investments, they work slightly differently. Here’s how.
With private equity, the investor will be investing in a company or another type of entity that isn’t publicly traded or listed.
Venture capital, on the other hand, is more focused on giving funding to young businesses or startups that have shown potential for growth that’s long-term.
Finally, there’s the convertible note form of business financing. A convertible note is a type of loan. It’s a short-term debt that is then converted into equity. Usually, investors will provide your business with money during your first financing round.
Then, instead of making their money back in the form of interest, they’ll get paid back in stock.
Convertible notes are a good choice for companies that need funding fast, as it’s a speedy process that’s easy in terms of setting them up legally.
Pros of convertible notes include being easy to document legally, they’re useful for accelerator investments, and you can raise funding between equity rounds that are larger.
Cons include that you might end up in a situation where you can’t pay back the note, and you could end up having to liquidate your business.
Need Assistance With Your Business Financing?
Now that you know about all the different ways you can use business financing to get the money you need to run your business or startup, you might need additional information.
That’s where Fundera comes comes in. Fundera is a business funding matchmaking service that connects those in need of funding with qualified lenders. With Fundera, small business owners can get curated financial solutions tailored to their business needs.
Related: Online Business Tools for Small Businesses