Most people instinctively think debt to be a bad word, however, for most startup companies it represents one of the most viable ways of financing operations and growing fast. Even very large companies tend to use the leveraging power of debt to achieve greater profitability. While banks, credit unions, and other financial institutions are typically the largest sources of debt, private companies and individuals can also give loans to startups.
Why Using Debt Is Advantageous for Business Owners
Sole available source of funds: In their early stages, startups and small businesses do not have established track records of turnover and profitability so it can be very difficult to put a valuation for an IPO to be made. Therefore, debt funds are possibly the only way by which, the companies can run their operations. While traditional lenders like banks and credit unions are reluctant to lend funds to startups and small businesses simply because they do not have an established record of profitability, little assets to pledge as collateral, and unstable cash flows to boot, business owners can take loans from family and friends, private money lenders or even use their credit cards to access funds for business operations. According to the SBA, business loans, lines of credit, and credit cards account for around 75% of the financing of new businesses.
Relatively quick processing: While raising money through equity offerings can be a long and cumbersome process due to the many technicalities and legal compliances, taking on debt is a relatively quicker method of accessing funds. All that is needed is a quick examination of the financials and credentials of the business and its owner and an agreement can be reached between the lender and the borrower regarding the amount of the debt, the interest payable, and the repayment schedule. This is a one-time exercise, and if further loans are required from the same lender the processing is even faster.
Retention of ownership: When debt is taken on by a borrower, the only obligation is to pay it back on time as per the terms of the agreement. The lender does not get any right to have a say in how the business is operated. According to forbes,this is one of the biggest pros of debt financing. In the case of equity financing, shareholders are entitled to have a say in how the business is run and can even take control of the business if they are a majority.
Tax benefit: A big attraction of debt financing is that both the principal and interest repayment can be treated as legitimate business expenses and can be therefore deducted from the income of the business. This has the effect of diminishing the profit of the enterprise and therefore the tax paid too is lesser.
The effective interest rate is lower: Since the amount repaid to the lender can be treated as a business expense it has the effect of lowering the profit. It is because of this that the real cost of debt funds is less than the rate of interest you pay to the lender. The benefit depends on the rate of company tax that you are liable to pay; typically, this is 30%, so in real terms, the rate of interest that you pay is less by the same figure.
Drawbacks of Using Debt Funds
An obligation to repay: Taking on debt is fine as long as the borrower has the ability to repay it as per the terms of the agreement. The obligation is completely insulated from the performance of the business, which means the repayments have to be made even if the business is not making a profit. In the case of repeated default, the lender can even move the courts to have the business liquidated. In that case, the debt repayment will have a preference and only after all the debt has been paid will the equity shareholders receive any residual value. If multiple debts are making money management difficult, consolidating them can be very useful. However, before deciding on the lender, it is advisable to read up on the debt consolidation loan feedback available online.
The requirement of collateral: Depending on the amount of the loan, the lender may insist on collateral assets. Essentially, this means that in case of default, the lender will have the right to sell off the assets to realize his dues. To ensure that this does not happen, the business owner has to ensure that the cash flow is sufficient for the debt repayments to be made.
Unfavorable rates of interest: Even though the interest paid on loans can be set off against the income of the business, lenders are likely to charge high rates of interest if they feel that the business is new and without an established track record of if your credit history is of concern. The cost of debt may make the operation of the business unviable. This is the reason why startups must not use credit cards or personal loans that typically carry very high rates of interest on a sustained basis to finance their operations.
Negative impact on the credit rating: It may be a very attractive proposition to keep on adding debt to be able to grow faster, however, business owners need to keep in mind that every time they take a loan, their credit score takes a hit. This is because with an increasing level of debt, the risk of default increases. Normally, lenders will try and compensate for the increased risk perception with higher rates of interest; though at some time they may also refuse to extend further loans.
Taking on debt needs to be a well-considered decision. This is because normally, the repayments start immediately after the loan is taken, which means that the cash flow of the business should be sufficient. Even profitable businesses can find themselves cash-strapped if sales realizations are not taking place normally or if investments have been made in assets that take time to generate returns. Debt financing can be especially tricky in the early stages of the business cycle because it is likely that the business will be losing money and therefore, not able to benefit from the tax advantage.
Kelly Wilson is an experienced and skilled Business Consultant and Financial advisor in the USA. She helps clients both personal and professional in long-term wealth building plans. During her spare time, she loves to write on Business, Finance, Marketing, Social Media. She loves to share her knowledge and Experts tips with her readers.