| Debt
Financing
"Money
is always there, but the pockets change." — Gertrude
Stein
Debt financing refers to what
we normally think of as a loan. A creditor agrees to lend money
to a debtor in exchange for repayment, with accumulated
interest, at some future date. The creditor does not obtain any
ownership claim in the debtor's business. Debt financing is
attractive because you do not have to sacrifice any ownership
interests in your business, interest on the loan is deductible,
and the financing cost is a relatively fixed expense.
Selecting a
Bank or Other Lender
- Banks
include traditional savings banks, savings and loans, and
commercial banks, and are generally the first place small
business owners think of when looking for institutional
financing.
- Credit
unions can offer generous terms to their members,
but make mostly consumer loans.
- Consumer
finance companies may be willing to make
higher-interest loans to higher-risk borrowers.
- Commercial
finance companies may be worth considering if you
need a loan for inventory or equipment purchases.
Specific
types of bank loans: In addition to consumer loans
and mortgages, the most common types of loans given by banks to
startup and emerging small businesses are:
- working capital lines of
credit for the ongoing cash needs of the business
- credit cards:
higher-interest, unsecured revolving credit
short-term commercial loans for one to three years
- longer-term commercial
loans: generally secured by real estate or other major
assets
- equipment leasing for assets
you don't want to buy outright
letters of credit for businesses engaged in international
trade
The
Real Cost of Borrowing Money: The final cost of
borrowing money often involves much more than just the interest
rate. A variety of other monetary and non-monetary costs should
be considered in determining the real cost of borrowing. For
example, a loan that requires you to maintain certain financial
ratios may be unrealistic for your particular business. Your
checklist for reviewing the costs of a bank loan should include:
Direct financial costs, such
as interest rates, points, penalties, and required account
balances
Indirect costs and loan
conditions, such as periodic financial reporting, maintenance of
certain financial covenants, and subordination agreements
Personal guarantees needed
to obtain the loan
What Banks
Look For
"Remember, the guy who
writes the bank's advertisements is not the same guy who
approves your loan." — Anonymous
Whether you are applying to a
bank for a line of home equity credit, a line of credit for
business working capital, a commercial short-term loan, an
equipment loan, real estate financing, or some other type of
commercial or consumer loan, many of the same basic lending
principles apply. The most fundamental characteristics a
prospective lender will want to examine are:
- credit history of the
borrower
- cash flow history and
projections for the business
- collateral that is available
to secure the loan
- character of the borrower
- loan documentation that
includes business and personal financial statements, income
tax returns, and frequently a business plan, and that
essentially sums up and provides evidence for the first four
items listed .
Asset-Based
Financing: To generate working capital or to meet
specific short-term cash needs, small businesses may use certain
short-term assets as collateral for commercial loans. The most
common types of asset-based financing are the following:
Accounts receivable financing
uses the receivables as collateral. As the business collects the
receivables, the proceeds are used to repay the loan or line of
credit.
Inventory financing is a
similar type of loan, using inventory as collateral.
Factoring is a process
whereby accounts receivable are actually sold to a third party
(the factor) for a discount price, after which the factor takes
on the job of collections.
Leasing:
Leasing companies, as well as banks and some suppliers and
vendors, will rent equipment and other business assets to small
businesses. Some manufacturers have leasing agents who may be
able to arrange lease terms or a credit arrangement with the
manufacturer, a subsidiary company, or a specific lessor.
Leasing assets, rather than purchasing them, is a form of
financing because it avoids the large down payment frequently
required for asset purchases and it frees up funds for other
business expenditures. However, you should be aware that leasing
from conventional lenders may be difficult for startup
businesses because traditional lenders require an operating
history from prospective lessees.
Trade
Credit: Your suppliers and your customers represent
possible sources of financing through a variety of credit and
pricing options.
"Trade credit" is the
generic term for a buyer's purchase of supplies or goods from a
seller (supplier) who finances the purchase by delaying the date
at which the price is due, or allowing installment payments.
Vendors and suppliers are often willing to sell on credit and
this source of working capital financing is very common for both
startup and growing businesses. Suppliers know that most small
business rely primarily upon a limited number of suppliers and
that small businesses typically represent relatively small order
risks; as long as the supplier keeps a tight rein on credit
terms and receivables, most small businesses are a worthwhile
gamble for future business.
Insurance
Companies: If you have substantial cash surrender
value in a life insurance policy you can usually borrow up to
that amount from your insurer. Ordinarily, you would borrow
against the policy and then re-lend the money to your business
at the same interest rate. The business can then take an
interest deduction on the loan and you do not earn taxable
interest income on the transaction.
When you borrow against your
own policy, you are not obligated to repay the loan principal,
only to pay interest on the loan. Interest is typically due on
an annual anniversary date. Most policies will allow you to
simply add the accumulated interest to the principal, as long as
you have not already borrowed up the cash surrender value of the
policy. The rate of interest charged depends upon when the
policy was purchased; rates on older policies might be very
favorable. Of course, borrowing against your own policy means
the eventual death benefit of the policy will be diminished by
the amount of the loan, plus the loss of interest.
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