What is debt financing for small businesses?

If you need outside funding to launch or grow your small business, you generally have two options: debt financing or equity financing.

Equity financing means someone else invests money in your business in exchange for an ownership percentage. For many small business owners, equity financing isn't an option—either because they want to maintain complete control over the business or can't attract the outside investors they need. If you find yourself in that position, debt financing may be your best bet.

Debt financing defined

Debt financing is borrowing money from an outside source and promising to pay it back in regular installments, plus interest, over time.

Debt financing can come from many sources, including:

• Loans from family and friends
• Bank loans
• Personal loans
• Government-backed loans, such as an SBA 7(a) loan
• Lines of credit
• Credit cards
• Equipment loans
• Commercial real estate loans

How to qualify for debt financing

Qualifying for debt financing depends on the type of financing you're seeking and the lender's requirements. However, most professional lenders consider the Five Cs of Credit to determine a small business owner's creditworthiness. Those are:

• Capacity. Capacity is your business's ability to repay loans. Lenders like to work with small businesses that have positive cash flow.
• Character. Character considers who you are as a borrower. For example, what is your educational background? Do you have any business experience? Having experience and a positive reputation in your industry can improve your chances of getting financing. Lenders may also consider the business owner's personal credit history and require the business owner to guarantee the loan personally.
• Collateral. Collateral is a secondary source of repayment for a loan. If you stop paying your loan for any reason, the lender can recover what you owe by taking collateral, such as equipment, vehicles, or inventory.
• Conditions. Lenders want to see that there is a market for the business and a clear purpose for the loan. You can demonstrate this with local, regional, and national economic data, a sound marketing plan, industry knowledge, and your experience running a business.
• Capital. The cash you invest into starting the business is your capital. Investing your own capital shows the lenders that you are serious about the business. Unfortunately, most lenders won't finance 100% of a business's startup costs.

Pros and cons of debt financing for small businesses

Understanding the pros and cons of debt financing can help you decide if it's the right way to fund business growth.

Pros:

• Debt financing won't dilute your ownership. Lenders don't have a stake in your business when you borrow money—only your promise to repay the debt. For small business owners who want to keep 100% control over the business, this makes debt financing more attractive than equity financing.
• Your lender won't have a claim on future profits. Your sole obligation to the lender is to repay the loan with interest. Once you repay the loan in full, the lender has no other claim to future business profits, unlike investors who expect to continue sharing in the business's success.
• Debt payments are predictable. As long as you borrow money for your small business with a fixed-rate loan, you'll enjoy a predictable repayment schedule.
• Loan interest is tax-deductible. For most small businesses, the interest you pay on a loan is a deductible business expense. Therefore, your company's after-tax cost of debt is lower than the amount of interest paid because of that tax savings.

Cons:

• The debt must be repaid, even if your business isn't turning a profit. With debt financing, you typically need to start making loan payments within 30 to 45 days of taking out the loan, regardless of whether you've made your first sale.
• It can be difficult to qualify for a loan. Getting a loan as a small business can be tough—especially for startups. Many lenders require a business to be at least two years old before they'll consider making a loan.
• You may be required to personally guarantee the debt. Though not always required, lenders often ask business owners to personally guarantee business loans, which means the business owner has to personally repay the loan if the business is unable to do so. This can negatively impact your personal credit score if you have late payments or go into default.
• Your collateral is at risk if you default on the loan. Putting up collateral for a small business loan carries with it the risk that you'll lose the asset if you default on the loan. Unsecured loans may be available, but they tend to come with higher interest rates.

Raising money for your small business and finding the right type of financing can be time-consuming. But it's important to consider your available options and find the funding option that is best suited to your current financial situation and business goals.