11 Types of Debt Financing. Pros and Cons of Debt Finance. Business Owner’s Toolkit – How to Finance Your Small Business.

October 18, 2011 by · Leave a Comment
Filed under: Finance, Small Business 

An alternative to financing through equity is debt.

The advantages of using debt financing are:
• the time to secure debt financing is usually shorter than equity;
• the cost of the money (principal and interest) is readily measurable;
• documentation costs for the transaction will probably be less than an equity transaction; and,
• the equity of the company is not diluted by new ownership.

The disadvantages to debt financing are:
• unlike equity, the company has to pay back debt;
• the company must carry debt on its balance sheet as a liability, which may make it less attractive to some investors;
• if the cash flow of the business is tight, debt service can put an undue strain on the finances;
• in many small businesses, commercial lenders require the principals to personally guarantee the debt and possibly pledge personal collateral; and,
• some lenders require rather onerous record keeping by the borrower, such as quarterly and annual financial statements—possibly audited— and impose restrictions on certain business transactions without the lender’s consent.

11 Categories of Debt Financing:

  1. Bank Loans
  2. Credit Cards
  3. Home Equity Lines
  4. Retirement Funds
  5. Life Insurance Borrowing
  6. Financial Brokers
  7. Reverse Mergers
  8. Factoring
  9. Revenue Participation/Royalty Financing
  10. Merchant Banking
  11. Private Debt

1. Bank Loans
One of the most common types of financing is bank loans. In order to obtain a bank loan for a new business, you may need to present a business plan or a loan proposal, which are similar documents.
The advantage of seeking a bank loan may be that you or your family has a preexisting relationship or history with a bank that makes the process easier.

In any event, a bank will focus on several things in reviewing your loan application.
First, they will want to know about your business (the business plan), how much money you need, and how you intend to spend it. Equally important is  demonstrating to the bank how your business intends to pay the loan back and over what time period. Financial projections are most helpful at this time.
Banks are in the business of loaning money—that is one of their main profit centers. Your task is to demonstrate to them that you are creditworthy and that the revenues from your company are likely to pay back the loan in a timely manner. You demonstrate your ability to pay back the loan through your financial projections. If you already have a history of running a profitable business, a historical financial statement coupled with a financial projection could win the day.
Unless you have substantial assets in your company and healthy annual revenues, banks are likely to look to the creditworthiness of the owners of the business. In other words, you and your partners’ credit histories will be checked and you may be required to submit a personal balance sheet.
In the case of a start-up business, many banks will require, as a condition of the loan, that each of the founders (and possibly their spouses) guarantee the loan. The demand for personal guarantees may also surface when you are signing a lease for your company office or plant. If you have to sign a personal guarantee, see if the bank will agree to remove it after some reasonable period. Commercial landlords tend to be more open to the eventual removal of personal guarantees than banks, but it never hurts to ask.
Banks charge interest for loans, which is deductible as a business expense to the borrower. Interest rates vary among banks and can be influenced by the type of loan made and the perceived credit risk of the borrower. You should explore the various types of bank loans available to your business to see what fits. For example, a line of credit allows you to draw funds when needed and only pay interest on outstanding balances.
An installment loan is usually for a certain sum that you pay back in payments
of principal and interest, similar to your home mortgage. Many business loans have a floating interest rate that adjusts with changes in a standard index, such as the prime rate.
Some banks may require that you provide security or collateral for any business loan. If your business does not have equipment or receivables, they may require you to put up your house and other personal property to guarantee the loan. If that is not enough, you and your partners, directors, and possibly principal shareholders will most likely have to sign personally on the loans as previously discussed.
If your company is writing a business plan and a bank loan is in the picture, you may wish to specifically address the issues the lending bank will consider in making a loan. As a practical matter, you will probably have trouble getting a loan as a start-up if you cannot demonstrate an ability to repay the loan from revenues. You should probably enlist the aid of your accountant to make certain that you tell your story in believable numbers.
You will also help your case by having substantial clients or orders in the wings to demonstrate imminent revenues. It also helps if you have invested your own money in the venture, as this demonstrates your commitment to the business and its success. In venture circles that is known as having skin in the game. Pledging collateral is another way to put skin in the game.
Another useful approach is to plan your presentation to the bank, preferably on your own turf, so that key employees are included in making portions of the presentation. If you are in a position to reduce or cut your own salary for some period of time, that will also impress the bank—they do not relish your seeking a loan to pay your own salary.
Larger, institutional banks are not the only game in town when seeking loans. Smaller, community banks are generally more connected with local people and may be more flexible. Innovative officers in small banks will try to syndicate or farm out portions of loans to other small banks to increase their lending limit.
You should not necessarily stop with banks as the sole source of lending.
Many venture funds, larger companies like GE Capital, and brokerage houses have bank-like divisions that could be a source of debt capital or some combination of debt and equity.

HOW TO Get a Bank Loan

  1. Prepare a business plan targeted to a lender rather than an investor.
  2. Present believable financial statements and projections that demonstrate that the company will have sufficient cash flow to service the debt and meet its operational budget.
  3. Interview the lender prior to submitting the package and find out exactly what type of presentation and information is expected.

 

2. Credit Cards
Many entrepreneurs use credit cards to initially finance their business. If you go this route, you need to treat the credit card debt as an installment loan and pay it back as soon as possible. You should also shop around to get the best rates credit card interest can be steep.
Establish guidelines for credit card borrowing. For example, do not borrow any money you cannot repay in ninety days. Make sure to keep accurate financial records that separate your personal expenses from business expenses. A good strategy is only to use credit cards for the purchase of a long-term asset like a computer, or for something that will quickly generate cash, like buying inventory to fill an order. Do not use credit cards to pay expenses that are not generating revenue.

3. Home Equity Lines
In the initial start-up phase of the business, other direct sources of financing include home equity lines. The home equity line is essentially
asset-backed borrowing.You could do the same thing with the business if it had assets to pledge. To obtain a home equity loan, you apply to a bank or financing institution and the loan is secured by a lien on your home, usually a second mortgage.

4. Retirement Funds
You can always use self-directed IRA accounts of investors as a source for financing. Owners of self-directed plans can make investments in private companies. However, there are certain disqualified persons who cannot engage in prohibited transactions with the IRA. Common occurrences of IRA prohibited transactions are (1) purchasing investments that will benefit the IRA holder (as opposed to the IRA itself) and (2) using the IRA as security for a loan. An example of the direct benefit example is having the IRA purchase a vacation home for your family. Disqualified persons include the IRA holder, his or her spouse, ancestors and lineal descendants of the IRA holder and spouse, and any corporation, partnership, trust, or estate in which the IRA holder has a 50% or greater interest. In calculating the percentage ownership of the IRA holder, the IRA attribution rules apply so that the interest of spouses, ancestors and lineal descendants are included.
In some circumstances, investors can utilize their 401(k) plans to invest in private companies.
Consult with a tax professional before making any investments from retirement accounts. If your investor is having trouble convincing your custodian to make an investment with their retirement account, you can set up a new self-directed account with a company that specializes in self-directed retirement funds.

5. Life Insurance Borrowing
You may also consider borrowing against your life insurance policy, assuming that you have the kind of whole life policy that builds cash value. The interest rates are less than credit cards, and the loan will stay in place as long as you continue to pay the premiums. If you die while the loan is outstanding, the benefits of your policy will be reduced.

6. Financial Brokers
You will undoubtedly cross paths with financial headhunters or brokers during your quest for financing. These individuals or companies usually work for a commission and typically want a portion of your company’s equity as part of their fee. You should exercise caution when employing a financial broker, since they are generally not licensed like stock brokers, attorneys, and accountants, and there is little public information available on them.
Always insist on references and do a thorough job of due diligence on the brokers. Avoid paying up-front fees if possible. If travel expenses are required, approve them on a case-by-case basis. Avoid signing an exclusive agreement with the broker, but if you must, have the period of exclusivity expire after thirty to sixty days if no meaningful results are forthcoming. In all events, make certain that the broker is not paid their fee unless financing actually occurs. Make sure you have the absolute right to decline any financing offered for any reason.

Many brokers will try to convince you that your business plan needs upgrading to an investor-grade business plan before they can present it, and that will cost you several thousand dollars for the makeover. If you have a solid business plan with CPA-blessed financials, politely decline the offer.

7. Reverse Mergers
The subject of reverse mergers, where a company merges into a publicly traded shell company, is well beyond the scope of this book. Any start-up company would be well-advised to avoid a reverse merger until they have raised several rounds of financing—and maybe not even then. While there are successful reverse mergers, the field is strewn with wrecked companies that have insolvable regulatory problems. Caution is advised. Make certain you consult with competent professionals before undertaking this route.

8. Factoring
Factoring, also known as receivables financing, is a popular form of raising capital. While it is not for everyone, it can be useful if your business has a large volume of receivables. Essentially, a factoring company advances to your company the value of a percentage of your receivables, less a fee, and assumes the responsibility to collect the factored receivables.
When you factor your receivables, you usually end up with between 50% and 90% of their value, depending upon the creditworthiness of your clients and your company’s collection history. When the factor collects the receivable, it forwards the balance to you less a fee that can range from 2%–7%. The advantage of factoring is immediate cash flow to the business without a long-term debt obligation. The disadvantage is that the process is fairly costly.

9. Revenue Participation/Royalty Financing
Revenue participation or royalty financing occurs when an investor buys a percentage of a future revenue stream of the company. This type of financing can be risky for the investor if there are no sales revenues or revenues do not occur for a time. When sales do occur, payment to the investor comes before any other expenses of the company, regardless of profitability.
In the current market of hybrid securities, a revenue or royalty component, coupled with some equity participation by way of warrants, can be an attractive option to investors seeking both cash flow and equity participation.
A version of royalty or revenue participation can be structured within a class of preferred stock or LLC membership units. The tax and legal aspects of this creative form of financing are complex, and careful planning with your legal and accounting team is advised.

10. Merchant Banking
Historically, merchant banks have not been commercial banks that accept deposits, but private banks with access to private equity funds. That said, many of the traditional lending banks have ventured into the private equity market in the past few years. With a little research, you may be able to uncover a source of equity financing from your bank. Larger banks have been investing in private equities for quite a while, and now small banks are getting in the game with some banks syndicating the investments with other small banks. It is unlikely your local branch officer will know much about these programs, and you may need to do a bit of digging to get to the right person in the bank. If you have a preexisting relationship with the bank, you will probably get answers a lot quicker.

In addition to the private equity groups of commercial banks, there are other private equity nonbanking groups, such as insurance companies, hedge funds, large and small angels, private equity funds, and other institutional investors who invest in early stage companies. Like an entrée into venture capital, an introduction to the group, especially from a person who has previously raised money from that sector, is extremely helpful.
11. Private Debt
A company can raise capital by offering a debt instrument to investors as opposed to an equity instrument. For example, the company could offer secured or unsecured promissory note obligations payable over time at a competitive interest rate. Private company debt, particularly the unsecured variety, is considered risky, and an above-market interest rate is necessary to attract private investors or lenders.

Many start-up companies offer a convertible promissory note in their early seed rounds. The convertibility feature of the note allows the holder (lender) to convert the amount due for principal and interest to an equity interest in the company. The conversion rate would be the amount at which equity interests in the company will be offered to new investors or at a discount to make the investment more attractive. If you use convertible notes or any debt instrument to raise early money, you should organize the entity first and have the note be issued by the entity rather than you personally.

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