Debt Financing – The Positives and Negatives of Each Funding Option

An overview of the main types of debt financing options available to business owners, and the positives and negatives of each option, including term loans, invoice financing and asset-based lending.

Debt Financing involves borrowing money from a lender, typically a bank or another financial institution, with the intention of repaying the loan back with interest over a specified period of time.

The lender will usually have a legal claim on the borrower’s assets in the event that the loan cannot be repaid and is defaulted.

The main advantage of debt financing is that you don’t have to dilute any ownership of your business and typically don’t have to give away much, if any, control.

However, as a provision of a loan, most lenders will expect to see regular management and financial reporting from the business and may expect to be included in management meetings or see detailed minutes.

Lenders may also want to have a veto or give a view on any major business decisions.

The main disadvantage of debt financing is that it can be more expensive than other financing options as you will have to pay interest on the loan. You will also have to take on a fixed obligation to repay the loan and keep up with an interest payment schedule.

And while you give up little control over the business, debt equity involves higher risk.

The lender will typically take a charge over the business, as a security for the debt, to protect their position and to get their money back if the business fails.

In this article we outline the main types of debt financing options that are available to business owners, and the advantages and disadvantages of each funding option…

Term Loans

This is a traditional loan – typically from a bank or other financial institution – that is repaid over a fixed period of time, with regular payments of principal and interest.

Typically, a business will need to provide a clear business case for the loan, such as to buy new equipment or to fund other capital expenditures.

The interest rate can be fixed or variable.

Depending on the lender’s requirements, you may be expected to provide management reports on a regular basis so that the lender is aware of any risks that you may default on the loan.

The lender will typically take a charge over the business, as a security for the debt, to protect their position and to get their money back if you default on the loan.

Line of Credit

This type of loan – typically with a bank or other financial institution – allows a business to access funds up to a pre-approved limit, with the ability to draw down on the credit line as required.

Lines of credit provide a business with flexibility and can be used to manage cash flow or respond to unexpected expenses.

However, the business may be required to pay interest on the unused portion of the line of credit.

Invoice Financing

Invoice financing allows you to borrow money against your outstanding invoices.

Typically, a lender will give you a percentage of your unpaid invoices upfront in the form of a loan or line of credit (usually up to 90% of the invoice). Once the invoice is paid by the customer, you pay back the amount loaned plus the agreed fees and interest.

Factoring is a slightly different form of invoice financing where you sell your outstanding invoices to a factoring company at a discount. The factoring company will give you a percentage of the invoice amount upfront (usually 80 – 90%) and then take responsibility for collecting the full amount from the customer.

Once the full amount is collected by the factoring company, you will get the invoice amount minus any fees charged by the factoring company.

This method of funding is particularly useful to small and growing businesses that need quick access to funds and help with cash flow, especially where clients can take several months to pay.

However, invoice financing can be more expensive than other forms of debt financing as interest charges, factoring fees and other admin costs can be higher.

Your profit will also be lower than if you collected the invoice yourself as you pay a portion of the full invoiced amount to the lender.

Equipment Financing

This is a loan used specifically for plant, machinery, and other types of equipment for the business.

Typically, the funds are secured against the equipment itself.

There are two main categories of equipment financing, capital lease and operating lease.

Capital Leases are usually non-cancellable, longer-term agreements used to lease equipment that a business needs for long-term use, such as plant and machinery. Usually, the business will have the option to buy the equipment at the end of the lease period.

Operating Leases are short-term and can be cancelled before the end of the lease period.

These are typically used when a business intends to use the equipment for a short period or plans to replace the equipment after the lease ends.

The main benefit of equipment financing is that it enables businesses to spread the costs of buying expensive equipment and the equipment itself is collateral for the loan.

Operating leases can also be particularly useful if technology will go out of date quickly and you need to upgrade every few years.

Asset-Based Lending

Asset-based lending is a type of debt finance in which a lender provides a loan based on the value of your business’s assets, such as real estate, inventory, or equipment.

Asset-based lending is a good option if you need quick access to cash, as typically you will get faster approvals with asset-based lenders than with conventional bank loans.

Another potential benefit is that the loan agreement is less a function of your credit score and more a function of the value of the asset.

However, interest rates are typically higher than with conventional banks and there is a risk of losing your collateral if you default on the loan.

You may also have to pay a fee on any unused funds borrowed.

Bond Financing

Bond financing is a type of debt financing in which a company raises money by issuing bonds to investors.

Investors buy a bond, and the company pays an agreed amount of interest to the investor over a fixed period of time. And at the end of the specified time period, the loan is repaid in full.

In essence, a mini-bond is an IOU from the business to an investor.

Mini-bonds are typically issued by issued by small or start-up companies, businesses that find it difficult to raise funds from institutional investors or companies who are unable to borrow money from a bank.

But because the level of risk to the lending individual is high, the amount of interest to be repaid is higher than a conventional bank loan.

The FCA provide more information about mini-bonds here but warn that “Investors should exercise caution when buying them” due to the high level of risk involved.

Download our free guide: How to Raise Finance for your Business

This article is taken from our free guide “How to Raise Finance for Your Business” which you can download below:

Leonherman’s Corporate Finance Services

If you’re looking to raise finance for your business then our corporate finance advisors can help you to choose the best option for your business and circumstances.

Our team of corporate finance advisors, led by Jerry Scriven, regularly help business owners with business planning, financial reporting, fundraising, management reporting and valuations and we’d be delighted to have a conversation with you to find out about your specific needs and ambitions.

On the other hand, if you are an investor or lender and you are looking for a trusted advisor to undertake due diligence, valuations or other advisory work before and after a finance deal, then we would be delighted to speak with you. Call us on 0161 249 5040 or email: partners@leonherman.co.uk.

Important Disclaimer

This material is published for information only. It provides only an overview of the regulations in force at the date of publication, and no action should be taken without consulting the detailed legislation or seeking professional advice. No responsibility for loss occasioned by any person acting or refraining from action as a result of the material can be accepted by Leonherman.

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