Business Debt - why, how, when and where?
The word “debt” has a negative connotation and that’s a shame, because when it’s used in a thoughtful and purpose-driven way, debt can make all the difference in a business’ success. Borrowing money can lift a fledgling business, giving it a strong foundation and the ability to move forward confidently before real revenue starts to flow. It can also make all the difference for established operations encountering unexpected dips, illness, or events that create a temporary cash crunch, or sudden surges that demand funding to stock up and meet the market’s needs.
Far too many entrepreneurs trade away equity in their business when the need for cash arises. Being familiar with the different types of debt – as well as when to use each type and where to get it from – will bolster your basic business knowledge, drive your success, and help keep your future firmly in your own hands.
Understand Your Needs Before You Dive into Debt
When your business needs cash there are plenty of options available, but they’re not all right for you or your situation. You don’t need a long-term loan to fund the redesign of your website, and a line of credit won’t suit the purchase of a new delivery truck.
The very first step, before you decide on a debt structure, is to assess and understand your own needs. That means answering the following questions:
· How much cash do you actually need, and how do you plan to repay it?
· What do you need the money for?
· Will the type of business you operate impact how consistently you’ll be able to make payments?
· Will you be able to qualify for a loan?
No matter how obvious the answers feel to you, keeping them in mind will inform your debt decisions.
Different Types of Debt (And When to Use Them)
Business financing options run the gamut from credit card and lines of credit to long-term loans with fixed payments. Each has its own purpose, qualification requirements, and costs.
Short- and Long-Term Loans
A term loan provides a specific amount of money provided in a lump sum, to be repaid with interest in regular payments over a specified period of time. They can be either short-term, intermediate, or long-term, lasting from just a few months to well over ten-years. The interest rate that is charged by the lender can be fixed or can change based on economic fluctuations.
Term loans offer numerous advantages.
· They generally charge lower interest rates than other types of loans and provide the greatest flexibility in terms of what they can be used for and how you can use them.
· They are particularly helpful for businesses that are not yet earning income, and who need cash for initial or capital investment. When a large enough lump sum is received it can be used to pay for big purchases and start-up expenses while still leaving the remainder for operational or unexpected expenses.
· Their repayment terms are predictable and can be built into operational expenses and budgets.
· Their application process is straightforward.
· The interest that you pay is tax deductible.
In addition to funding your start up, term loans can be used to finance expansion into a new location or to purchase equipment to increase production capabilities. Short-term loans can also be helpful for financing the development of a new product.
Asset-Based Credit Lines
A favorite of small and mid-sized companies facing short-term cash needs, asset-based credit lines allow business owners to leverage the value of existing assets such as inventory, equipment, and even accounts receivable. Asset-based credit lines are only available to businesses, and the amount a lender is willing to provide is often dependent upon the liquidity of the item or asset being offered as collateral. Securities will garner a loan representing a higher percentage of their value than a piece of equipment that would cost the lender money to liquidate in case of default.
There is a variation on asset-based lending that relies entirely on accounts receivable. Known as factoring, rather than using money owed to you as collateral the lender provides a cash advance on the revenue that you are owed. The lender pays you up to 90 percent of the amount that you are billing based upon your clients’ credit history, as the lender collects the face amount of the invoice directly from them. They incur the cost of collection and retain the balance for themselves.
Asset-based credit lines offer several advantages.
· Provides quick access to cash based on asset value rather than income.
· Line of credit is flexible based upon the assets used as collateral
· Choosing factoring eliminates collection efforts and expenses with no debt accumulation
For businesses with cash-flow concerns and a robust inventory or accounts receivables, asset-based credit lines can fund payroll, pay for new materials or equipment, and provide working capital.
Non-Asset-Based Credit Line
When cash flow is a problem and you’re lacking collateral assets to offset a loan, an unsecured line of credit offers another option. It works in much the same way that a credit card does, offering cash in hand that can be used for any purpose. As soon as an amount is disbursed from the approved line the withdrawal begins accumulating interest charges. Once the amount and accrued interest is repaid the funds are again available. The amount of the credit line and the interest rate you are charged will depend upon a number of variables, including your credit history.
Non-asset-based credit lines offer several advantages.
· They help keep your business operating despite cash flow challenges
· Rates tend to be lower than those offered for business credit cards
· There is no need to put up collateral
· Many lenders offer them for amounts as high as $100,000
· They do not need to be used for a specific purpose
· They can help a new business to establish a solid credit rating
An unsecured line of credit can help you pay for business expenses as they arise. They can offset the negative effects of seasonal downshifts, providing the cash needed for supplies, payroll, inventory, and growth.
Where to Go for Financing
If you’re interested in availing yourself of any of the debt instruments listed above, your next step is to find lenders willing to work with you. A quick Google search will reveal that there are plenty of options and financial institutions who are eager to work with you. These include:
· Banks and credit unions – The most traditional and reliable resource for financing, brick and mortar banks and credit unions have lots of options available, but their accessibility and reputations have been built on a legacy of strict requirements, time-consuming application processes, and a cautious approach to lending that may work against businesses without an established credit history.
· Online/Fintech banks – Online banks are increasingly popular and offer the advantage of being accessible anytime, from anywhere that you have internet access. Most offer a full suite of business loan products via quick applications and lenient requirements.
· The Small Business Association (SBA) – Though the Small Business Association doesn’t actually lend money to entrepreneurs, it offers a wide range of loan programs through traditional institutions and guarantees all or part of those loans. The additional layer of protection that the SBA’s guarantee provides to lenders can facilitate approval and speed the process.
Among the loans the SBA offers are:
o The 7(a) program that offers loans of up to $5 million
o The microloan program that provides startup financing of between $500 and $50,000
o The CDC/504 program makes funding available through nonprofit lenders for the purchase of major fixed assets up to $5 million with repayment terms of up to 20 years and interest rates based on current treasury rates
· Equipment financing companies – If you are considering taking on debt to finance the purchase of a specific piece of equipment, you may find that the manufacturer offers discounted interest rates for borrowers who work with their preferred or associate lender.
· Credit cards – When cash is short it is tempting to turn to your business credit cards to fund necessary expenses. Though this answer is convenient and reliable, it also comes at significant cost in terms of high interest rates. If you have a dedicated business account, you may find that the backing bank offers lower rates for term-loan-type purchases.
· Microlending companies and crowdfunding platforms – These innovative sources of funding connect entrepreneurs to individuals or groups of people willing to provide the amount needed. The peer-to-peer microlending loans generally carry above-market interest rates, while the crowdfunding platforms offer early, discounted access to the borrower’s products.
· Friends and family – The oldest and most familiar (literally) form of financing, though friends and family are often more than willing to provide needed funds, business owners may not want their loved ones vulnerable to risk of loss. There are also emotional complexities that come with involving family members, who may expect to be consulted on business decisions.
Advantages and Disadvantages of Taking on Debt
Business owners who view debt with a healthy level of respect will find it offers multiple advantages. These include:
· Debt provides the funds you need for your business without having to sacrifice control of your business (as would be the case when offering equity in exchange for cash).
· Any interest that you pay on business debt can be written off as a tax deduction.
· Paying down a debt has a positive impact on your business’ credit rating.
That being said, there are downsides that should be kept in mind, including the administrative requirements involved with the loan application, the interest you will be charged, and the possibility of personal liability for business’ loans secured with a personal guarantee.
Moving forward with your debt decision
Identifying the right type of debt product for your business and your needs requires a thorough analysis of the costs involved, the terms being offered, and your ability to pay. For assistance in identifying the smartest solution for your business, contact PPS solutions and enlist the help of a Fractional Finance team. Our guidance has facilitated smart financing for countless business owners and entrepreneurs. Contact us today at www.ppsfinance.com to set up a time for a consultation.