As your business expands, you must consistently infuse fresh funds to sustain its growth. One option to do so is for founders to continue bootstrapping their ventures. However, in most cases, the business, fortunately, grows so large that it becomes difficult for founders to continue financing it.
Another option most businesses look towards is equity financing, where founders need to forgo a significant portion of their stake in exchange for fresh capital. Although the risk of equity financing is minimal lest your business idea fails, it is not a good proposition for founders who want full control over their growing enterprises.
Debt financing is thus an ideal option, where you are able to preserve your equity and are promised a mutually agreed capital with the promise of timely repayment. However, it is crucial that you understand the ins and outs of debt financing before you go ahead and apply for the same, and in today’s post, we will help you do just that.
What is Debt Financing?
In simple terms, debt financing can be understood as a type of financing wherein a lender lends you a fixed amount of working capital and insures it against an asset. For example, if you want to purchase new equipment for your manufacturing plant, then the lender will issue you a loan using your equipment as collateral.
One of the most significant advantages of debt financing is its affordable interest rates and approved capital, making it an attractive proposition among founders with significant assets and collateral.
Types of Debt Financing
Most people associate debt financing with a traditional bank loan; however, today, there are multiple options available to founders, ranging from credit lines to merchant cash advances.
1. Instalment Loans
The most popular form of debt financing is an instalment loan. In an instalment loan, the borrower needs to repay a certain amount to the lender every month until the total debt (principal plus interest) is repaid. In most cases, traditional financial institutions such as banks issue instalment loans and they assess the overall businesses to decide on their eligibility.
Although the eligibility criteria for bank business loans are slowly changing, start-ups with less than 2 years of business vintage, asset-light establishments or those with poor credit ratings won’t generally get approved.
Along with this, most lenders in this sector mandate the founder to pledge a personal asset such as property or mutual fund investments to reduce the associated risk thus further reducing its allure.
An exception to this is government-secured loans, wherein the federal government will act as the guarantor of your loan, thus excusing you from pledging personal collateral. However, in this case, as well, getting approved by the government is a difficult and time-consuming process.
Thus, instalment loans are best for businesses which have been operational for some years or whose founders are willing to pledge personal collateral.
2. Credit Financing
Most founders approach traditional financial institutions such as banks as their first source of funding. However, as most of these institutions run on legacy infrastructure, often, early-stage founders are rejected for their lack of credit score. While we can all debate on how this is an unjustified and unfair appraisal method, especially for growing businesses, it is what it is.
3. The Sacred VC Inner Circle
The next debt financing option available to you is credit financing which usually has a more lenient eligibility criteria as compared to instalment loans. Although your business might get easily approved for credit financing, they generally have a shorter repayment tenure and higher interest rates as compared to instalment loans.
The two most common credit financing options available to founders are a business credit or a home equity line of credit (HILOC). To get approved for either of these options, founders need to pledge some form of personal collateral, and since the interest rates are steep (30% to 40% per annum), it is better to generally use these as secondary or backup funding sources.
However, one benefit of credit financing is that the lender will generally increase your credit limit once you have a history of making timely payments, thus empowering you to capitalize on more opportunities further down the line.
4. Merchant Cash Advance
Merchant cash advance (MCA) is probably the most expensive form of debt financing available to founders. For starters, this type of financing provides an advance based on the lender’s assessment of the business, meaning this is not a loan. Along with this, most MCA lenders charge a high-interest rate between 20% to 40% and mandate you to share a percentage of your future revenue as repayment.
One of the most significant benefits of an MCA is that it empowers founders to inject fresh capital into the business almost instantly. Since most lenders in this space have completely online application processes, all entrepreneurs need to do is sync their banking system with the lender, and they can secure approval within 48 business hours.
Along with this, many MCA lenders offer you a line of credit after assessing your business, meaning you will only pay interest on the exact amount you borrow, and you will always have access to some excess runway for urgent expenses.
5. Your Community is Helping you Grow
Every business, irrespective of the industry, thrives on its customer base. As you have already spent countless hours nurturing a loyal community and customer base, you are set to reap the result of consistent demand for your product and services.
However, just like our last point, the question remains as to how you meet this new demand for your products. Added to this, it is difficult to translate a loyal customer base into actual business metrics to convince investors.
Thus, this is your indication to look into alternate sources of funding.
Advantages and Disadvantages of Debt Financing
Now that we have a better understanding of the various types of debt financing options available in the market let’s take a closer look at their advantages and disadvantages.
Pros
The biggest advantage of debt financing is that it allows you to preserve your equity. As a rapidly growing business, the potential value of your stake can be very high and thus, having the ability to retain it is key. Along with this, debt financing promises you a fixed amount of capital, which will not change once the agreement is signed. This offers you stability and helps you efficiently extend your runway without causing a huge financial strain.
Cons
Although debt financing has some advantages, most modern businesses cannot qualify for them as lenders often have stringent eligibility criteria’s. For instance, banks and traditional establishments require your business to be operational for at least 2 years to get approved. Added to this, most first-time founders won’t have access or will not be willing to pledge their personal collateral or assets, adding to their overall difficulty.
Lastly, if you can’t secure the government’s approval to act as your guarantor, then interest rates might get steep, which will ultimately burn a hole in your pocket.
Conclusion – Secure Financing on your Own Terms
As a business owner, it is not easy to secure financing when you need it the most. However, with changing government regulations and the entry of new-age lenders, things are starting to change for the better.
Financiers like CrediLinq are actively working towards this goal by offering products such as recurring revenue financing, which empowers founders to instantly access up to SGD$300,000 in capital without diluting equity or pledging personal collateral. To know more, get in touch with us today.
