How to Use Your Debt to Finance Your Business
Everyone knows by now that starting a company requires some money up front to get things off the ground. In today’s startup culture, raising capital with the help of investors and GoFundMe campaigns (equity financing) seems to be all the rage, but what people aren’t talking about are the potential cons of moving in that direction. Sure, it’s nice to have the money you need and the names of some big investors backing you, but in the long-term, you could be giving up a large percentage of your company for money you could’ve gotten an easier, cheaper way.
The word “debt” leaves a nasty taste in the mouths of many, but with 99.95% of businesses never getting venture capital, debt financing is actually one of the best ways you can raise capital for your company without sacrificing ownership. Debt can be very manageable if you understand your business and are careful with your expenses. With a line of credit and bank financing, you’re able to have the money you need to start your business the right way while still holding on tight to your stake in the company.
Here are some pros and cons of utilizing debt financing for your company.
- Maintain Ownership: When you borrow from your bank or another lender, you contractually promise to make payments on time based on your agreed-upon payment schedule, but this is where your obligation to the bank ends. Because you simply borrowed money without releasing stakes in your company, you’re able to run your business however you choose without outside interference (unless, of course, you default on your loan payments). If you go the investor route, however, chances are you will need to give up part of your ownership in the deal. These partial owners now have legal say in how your business is ran, plus they profit from all of your hard work. Don’t give up ownership unnecessarily.
- Tax Deductions: This is a huge attraction for debt financing. In most cases, the interest payments on a business loan are classified as business expenses and can be deducted from your business’s income during tax season. In this case, it helps to think of the government as a “partner” in your business who has an ownership stake (whatever your business tax rate is).
- Lower Interest Rates: In some cases, the interest rate on your bank loan is significantly less than the business taxes you’d pay each year. For example, if the bank is charging you 10% for your loan and the government taxes you at 30%, there’s a potential advantage in taking out a loan you can deduct later on.
- Repayment: Contrary to equity financing, your sole obligation with debt financing is to make on-time payments to your lender. You claim full ownership of your company and have the freedom to run your business how you’d like. However, if your business fails, you are still required to pay back your loan, and if you’re ever forced into bankruptcy, your lenders will have a claim for repayment before any equity investors.
- High Rates: Despite the potential discounted interest rates from your tax deductions, you may still have to combat high-interest rates because they vary based on macroeconomic conditions, your banking history, your business’s credit rating, and your personal credit history. All of these can have an impact on the interest you end up paying, so it’s important to take your time and do your research before jumping into any contracts.
- Impacts on Your Credit Rating: When your company needs money, it might seem attractive to bring on more debt instead of giving up ownership to investors, but each loan you take out will be noted on your personal credit report and can negatively affect your credit rating if they’re not handled properly. Additionally, the more you borrow, the higher the risk is to the lender, so you’ll most likely end up paying a higher interest rate on each subsequent loan.
- Cash and Collateral: Debt financing is a great option, but the point of the loan is to give you some wiggle room to work. If your company is not profitable to begin with, you could run into some problems. Even if your plan is to use the loan for an important asset, it’s imperative that your business is generating sufficient cash flow by the time the loan repayment is scheduled to begin. In addition, you may also be asked to put up collateral to protect the lender in the event you can’t pay on time.
Choosing between debt or equity financing really comes down to what best suits you and your company. Do some research on what is common in your industry and among your competitors. Make some realistic projections of your numbers, including your repayment amount, interest rates, and potential equity cuts. Then, and only then, if the advantages outweigh the risks, take the leap with the best option for you and your business.
Debt or equity financing? Which one makes the most sense for you and your business?