Debt financing is a popular funding source for growth-focused businesses but is often ignored by startups and scale-ups. It comes in various forms with both benefits and drawbacks, making it essential for businesses to understand them and determine if this type of financing aligns with their growth phase and business goals.
In the current economic environment of rising rates and decreasing access to capital, debt financing should be considered as a funding option for startups and scale-ups. In this article, we explain what debt financing is and when you should consider this type of financing for your business.
What is Debt Financing?
Also known as debt capital, debt financing is essentially a loan paid back over time with interest. There are many different types of debt financing, and they can be classified in several ways: secured vs. unsecured debt, alternative financing, revenue-based financing, and tax credit financing. The type of debt financing a business can obtain depends on various factors, including the company’s revenue, time in business, assets, and profitability.
Debt capital can either be secured or unsecured. Secured debt has collateral as loan security and can be taken by the lender if payments are missed. On the other hand, unsecured debt is not secured with collateral, but if a personal guarantee is required, the lender could seize your personal assets if you default on your loan.
Debt financing includes traditional bank loans as well as alternative financing from non-traditional sources. We describe the more common debt financing options below.
Bank Loans and Other Forms of Traditional Debt
Loans offered by banks usually have the most favourable rates and terms and come with a variety of options, including secured term loans and lines of credit, equipment loans, and unsecured business loans.
Term loans are a type of business loan that provides the business with a lump sum of cash that can be paid back in an agreed-upon number of months. Term loans can have a fixed rate or an adjustable rate. With a fixed rate, your payments are consistent and predictable, which helps you manage your cash flow. A variable or adjustable rate may be attractive, given that the initial rate may be lower than a fixed rate. Variable rates are often tied to an index such as the prime rate. If the index rate drops, so do your interest rate and payment; however, if the index increases, as we’ve seen over the course of 2022, so do your rate and payment, which could negatively impact your cash flow. Term loans are ideal for large purchases or fixed assets such as equipment, machinery, or real estate.
A line of credit is a type of revolving credit that allows you to borrow up to the approved limit. Like a credit card, you can borrow any amount up to the credit limit. Interest charges are only assessed on the outstanding balance, but if you just pay the minimum every month, interest charges add up pretty fast. A line of credit is ideal for businesses with lumpy cash flow and the need for funding to cover income gaps.
Banks also offer business overdrafts which are essentially extensions of credit that a business can leverage if its account reaches a zero or negative balance. Overdrafts can be beneficial for businesses that need immediate access to funds to cover short-term cash flow gaps. Accessing overdraft funds helps businesses avoid costly non-sufficient funds (NSF) fees. If overdraft funds are accessed, interest is only charged on the amount used.
Business Credit Cards
Business credit cards are a form of unsecured debt that provide businesses with a flexible and convenient way to purchase goods and services without tapping into their cash reserves. Many credit card providers offer different benefits such as low introductory rates, points, and other rewards like frequent flyer miles and access to airport lounges. Credit cards are also a great way for authorized company representatives to make needed purchases that are trackable and manageable by the company. Furthermore, many providers offer insurance protection against employee misuse and protection against theft, loss, or damage of purchased products. However, it’s important to be aware that interest rates on credit cards are higher than on traditional debt, and the interest charges compound daily. If the balances are not paid off every month, interest charges could get out of hand.
While there are many benefits of traditional debt financing, one of the major downsides is that traditional debt is harder to qualify for, especially for younger companies that can’t meet banks’ rigid revenue, credit, and time-in-business requirements. For newer businesses, alternative financing may be a great option.
While alternative loans have been around as long as traditional loans, this type of financing gained momentum during the global financial crisis of 2008 when new regulations and stricter requirements disproportionately impacted banks.
Alternative financing refers to sources of capital offered by non-bank institutions. This includes peer-to-peer lending, online lending, crowdfunding, invoice financing, and R&D financing.
Online Options, Including Peer-to-peer and Crowd Financing
Peer-to-Peer (P2P) lending enables borrowers to get funding directly from other individuals. P2P is also referred to as social lending or crowd lending and is often facilitated by an online lending marketplace like Lending Loop.
P2P lending offers clear advantages, such as an easy online application process and the ability to get approved in minutes or days. And because everything is done online, you don’t need to meet face-to-face with loan underwriters or bank personnel. Additionally, P2P interest rates are usually lower than other alternative financing options.
There are some disadvantages to P2P lending. For example, since it’s a newer form of financing, crowd lending is not as regulated as the banking industry, so if you’re concerned about privacy and data security, P2P may not be a good choice for you. Another disadvantage is that even though approval may be fast, it may take weeks to get funded, so if you’re in a rush, there may be better options.
Invoice Financing and Factoring
Invoice financing and factoring are often confused as the same thing, and while there are many similarities, there are a few notable differences too.
Both financing methods are ideal for B2B businesses that offer net terms to their accounts and need fast access to capital. This type of financing is also easier to qualify for than traditional financing, especially for startups and borrowers with bad credit. However, invoice financing and factoring can be expensive.
With invoice financing, also known as invoice discounting or accounts receivable financing, businesses can borrow money against the value of accounts receivable issued to customers that have not yet been paid. The lender can provide the cash up front – up to a certain percentage of the outstanding invoice balance in the form of a loan or a line of credit. Once your slow-paying accounts remit payment on the outstanding invoices, your business pays back the lender the amount borrowed plus interest and fees.
Invoice factoring, also known as accounts receivable factoring, is a financing method where businesses sell their outstanding invoices to a factoring company at a discount for cash upfront. In factoring, the company that purchases your invoices is responsible for collecting the total amount from the clients whose invoice(s) you sold at a discount. Once the factoring company collects the full payment from your customer, they send you the rest of the amount owed minus fees. In invoice factoring, your customer pays the factor directly instead of paying you, as is the case with invoice financing.
Revenue-based financing (RBF) is a lump-sum payment from a lender to a business in exchange for a portion of its future revenue plus fees. The advantage of an RBF is that loan repayments link to the business’s revenue, so payments adjust with sales fluctuations. During slow months, payments are lower, and during high-revenue months, loan payments are higher, which can help accelerate loan pay–off. RBFs are easier to qualify for than traditional loans, as they use monthly recurring revenue (MRR) as the basis for approval rather than business credit or business tenure. RBF terms are usually longer (3-5 years) compared to other alternative financing options, but it can be costlier than traditional financing.
This type of alternative financing allows a company to borrow against future R&D tax credit refunds, such as the Scientific Research and Experimental Development (SR&ED) tax incentive program offered by the Canadian Revenue Agency (CRA). Canadian businesses can apply for SR&ED financing and get cash in as little as 48 hours after approval. Additionally, they can continue to draw down from their accumulating tax credits through the year as they accrue more. The lender uses future tax credit refunds as collateral for the loan.
While the interest rates may be slightly higher than traditional financing, SR&ED financing rates are lower than most other forms of alternative financing because the loan is secured against government receivables, which have a high likelihood of payback. It’s a desirable choice for businesses seeking quick access to capital throughout the year. SR&ED financing does not require giving up equity, nor does it negatively affect cash flow, as there is no monthly loan servicing required. Principal and fees settle when the tax refund disburses.
The Takeaway on Debt Financing
If you’re considering sources of capital for your business, many types of debt financing are available, including bank and alternative financing. Alternative financing is a good option for newer businesses that are non-revenue generating or lack the financial history that builds up strong credit.
With today’s rising rates and decreasing access to traditional sources of capital, debt financing is a viable and attractive funding option. Businesses must consider whether debt financing aligns with their business goals and growth stage. This article aimed to provide an overview of debt financing and when it might be suitable for your business.
Talk to the experts at Easly if you want to learn more about alternative financing, including SR&ED financing.