Debt is an obligation that companies have to pay back steadily over a period of time plus interest. A common mistake first-time business owners make is to think about debt in absolute terms. The real deal is debt is not always good or bad for a business. Here is what you need to know:
5 Advantages of Debt Capital
- Wide variety of debt options.
Today, banks and finance companies offer a wide variety of debt funding “products” which can help business owners meet different kinds of funding needs. The most common types of business debt include credit cards, lines of credit, factoring, commercial mortgages, acquisition finance, micro-loans and secured and unsecured term loans.
In addition to more innovative lending products, providers of debt are online and offline in just about every community. With over 90,000 bank branches in the United States plus commercial finance companies, it’s easier for business owners to identify sources of debt than sources of equity.
- Lower cost of capital.
For profitable, revenue-generating businesses, the right kind of debt can be less expensive form of business funding than equity. This is especially true for business owners who believe that their businesses can grow steadily in value without equity capital.
- Maintain ownership control.
Unless the terms of the debt agreement involve some form of warrantor convertible debt security, debt does not usually dilute the founder’s percentage ownership in a business.
- Operating flexibility.
Most debt agreements allow businesses to pay off loans earlier than scheduled. This incentivizes business owners to shop for lower priced debt terms from competing banks or other financial service companies at any time.
- Leverage potential.
Well-established businesses with predictable cash flow may be able to utilize debt to help acquire other businesses to boost market share, profit potential and shareholder value. If the acquisition proves successful, company shareholders enjoy the benefits of owning a stake in a more valuable company that was paid for through debt rather than dilutive and more costly equity.
5 Disadvantages of Debt Capital
- Consumes precious working capital.
Most debt agreements require the business to pay interest and principal payments on a monthly or quarterly basis. As such, companies have to closely monitor and reserve enough cash to make loan payments on time and as agreed. Missed or late payments can lead to penalties and interest payment increases which only increases the amount of precious cash flow that companies have to hand over to lenders.
In contrast, funding a business with equity allows businesses to reinvest precious cash flow from customer sales in initiatives that can lead to even greater business growth.
- Personal guaranty.
With few exceptions, startup and early-stage business owners have to personally guaranty the payment of business loans. Sometimes personal guaranty terms are presented in a prominent way to borrowers, while other times the obligation is buried in the fine print of the credit agreement. If a business is unable to pay the debt obligation, then creditors can turn to the owner’s personal assets for payment. The bigger the obligation, the more likely lenders will seek repayment from the owner’s savings or home equity. Yikes!
- Rigid credit scores, collateral and cash flow.
Most business owners think that investors are harder to please than lenders. Not true! Investors can bend their investment criteria if they want to, but most bank lenders can’t.
- Risk adverse.
Because of federal laws which govern the banking industry, lenders must avoid lending to businesses that are deemed to be a high risk for loan non-payment. While investors are attracted to high growth business opportunities, the language of lenders is security, stability, predictability, conservatism and accountability.
- Changing credit availability.
As the 2008-2009 recession demonstrated, banks and finance companies can change the terms or availability of business credit whenever there is an economic hiccup or other disruption in the credit markets. Even highly liquid businesses with a perfect payment record can suddenly lose their working capital lines of credit altering their ability to fulfill customer orders or pay bills.