Debt Financing

2. Debt Financing

Debt financing is a strategy that involves borrowing money from a lender or investor with the understanding that the full amount will be repaid in the future, usually with interest. In most cases, debt financing does not include any provision for ownership of the company (although some types of debt are convertible to stock). Instead, small businesses that employ debt financing accept a direct obligation to repay the funds within a certain period of time. The interest rate charged on the borrowed funds reflects the level of risk that the lender undertakes by providing the money. For example, a lender might charge a startup company a higher interest rate than it would a company that had shown a profit for several years. Since lenders are paid off before owners in the event of business liquidation, debt financing entails less risk than equity financing and thus usually commands a lower return.

ADVANTAGES AND DISADVANTAGES OF DEBT FINANCING

Experts indicate that debt financing can be a useful strategy, particularly for companies with good credit and a stable history of revenues, earnings, and cash flow. But small business owners should think carefully before committing to debt financing in order to avoid cash flow problems and reduced flexibility. In general, a combination of debt financing and equity financing is considered most desirable for small businesses. In the Small Business Administration publication Financing for the Small Business, Brian Hamilton listed several factors entrepreneurs should consider when choosing between debt and equity financing. First, the entrepreneur must consider how much ownership and control he or she is willing to give up, not only at present but also in future financing rounds. Second, the entrepreneur should decide how leveraged the company can comfortably be, or its optimal ratio of debt to equity. Third, the entrepreneur should determine what types of financing are available to the company, given its...