1. Money

Debt Financing - Pros and Cons

Managed well, it can be an effective vehicle to help grow your business

By

What is Debt Financing?

Debt is borrowing money from an outside source with the promise to return the principal, in addition to an agreed-upon level of interest. Although the term tends to have a negative connotation, startup companies often turn to debt to finance their operations. In fact, even the healthiest of corporate balance sheets will include some level of debt. In finance, debt is also referred to as “leverage.” The most popular source for debt financing is the bank, but debt can also be issued by a private company or even a friend or family member.

Advantages to Debt Financing

  • Maintain ownership: When you borrow from the bank or another lender, you are obligated to make the agreed-upon payments on time. But that is the end of your obligation to the lender. You can choose to run your business however you choose without outside interference.
  • Tax deductions: This is a huge attraction for debt financing. In most cases, the principal and interest payments on a business loan are classified as business expenses, and thus can be deducted from your business income taxes. It helps to think of the government as a “partner” in your business, with a 30 percent ownership stake (or whatever your business tax rate is). If you can cut the government out of the equation, then it’s beneficial to your business.
  • Lower interest rate: Furthermore, you should analyze the impact of tax deductions on the bank interest rate. If the bank is charging you 10 percent for your loan, and the government taxes you at 30 percent, then there is an advantage to taking a loan you can deduct. Take 10 percent and multiply it by (1-tax rate), in this case it’s: 10 percent times (1-30 percent), which equals 7 percent. After your tax deductions, you’ll be paying the equivalent of a 7 percent interest rate.

Drawbacks to Debt Financing

  • Repayment: As mentioned above, your sole obligation to the lender is to make your payments. Unfortunately even if your business fails, you will still have to make these payments. And if you are forced into bankruptcy, your lenders will have claim to repayment before any equity investors.
  • High rates: Even after calculating the discounted interest rate from your tax deductions, as explained above, you may still be faced with a high interest rate. Interest rates will vary with macroeconomic conditions, your history with the banks, your business credit rating and your personal credit history
  • Impacts your credit rating: It might seem attractive to keep bringing on debt when your firm needs money, a practice knowing as “levering up,” but each loan will be noted on your credit rating. And the more you borrow, the higher the risk to the lender, and the higher interest rate you’ll pay.
  • Cash and collateral: Even if you plan to use the loan to invest in an important asset, you’ll need to make sure your business will be generating sufficient cash flows by the time loan repayment starts. Also you’ll likely be asked to put up collateral on the loan in case you default on your payments.

Alternatives to Debt Financing

  • Equity financing: This involves selling shares of your company to interested investors, or putting your own money into the company.
  • Mezzanine financing: Lenders who set up this debt tool offer the business unsecured debt (no collateral is required). The tradeoff is a high interest rate, in the 20- 30 percent range. Plus there’s a catch. The lender has the right to convert the debt into equity in the company if the company defaults on payments. Despite the high interest rate, mezzanine financing appeals to entrepreneurs because it offers quick liquidity, and even though it can be converted to equity, the issuing bank usually does not want to be an equity holder, meaning they’re not looking to control the company.
  • Hybrid financing: Most likely you’ll turn to a combination of debt and equity financing to fund your venture. The question then becomes: What is the proper combination? When deciding optimal capital structure, a common finance theory is the Modigliani-Miller theorem, which states that in a perfect market, without taxes, the value of a firm is the same whether it is financed completely by debt or equity or a hybrid. This, however, is considered too theoretical since real companies do have to pay taxes, and there are costs associated with bankruptcy. There are several other theories and formulas on determining optimal capital structures.

©2014 About.com. All rights reserved.