Need a Cash Injection? Debt Financing May Be the Answer

 

There are a number of ways for small businesses to overcome short-term cash flow, but two of the most basic methods to get some cash into your business are equity financing and debt financing. Last week I explained the pros and cons of equity financing. Here are some basics of debt financing.

 

 

When you raise debt, you basically sign a contract where you receive a given amount of money from the investor, and commit to pay it back in addition to some interest, according to an agreed-upon schedule. Although at first glance it seems like equity financing is a much “sweeter” deal, debt financing has many advantages:

 

• You don’t give away a part of your company. It remains yours. This is even truer if your company is growing quickly. In such a case, debt can be a good way to get cash, while increasing the value of your company. As a result, you are not forced to give a part of your company relatively cheaply.
• Debt is much easier to raise than equity, because the debt holder usually has liens or asks for a collateral that protects him in case of default.
• Many times, debt interest payments can be deducted from your tax payments (this is known as “Tax Shield”), effectively reducing the cost of debt.
• For companies that are doing well, debt can be a good “stick” to keep the management on its toes.  

 

However, debt has also some significant disadvantages to consider:

 

• You must be able to pay your debt repayments meticulously and punctually. If you miss a payment, many lenders will charge you steep fines, and will possibly inform rating agencies—limiting your ability to borrow in the future. If your business’ cash flow is lumpy or irregular, or you are just not a very organized person, be very careful before you borrow.
• Lending can be a “death spiral”. If you can’t pay your current debt, you might be tempted to borrow from another lender to cover it. However, most likely this lender will charge you higher interest rates, causing you to sink deeper into a debt you can’t pay.  

 

Lenders usually, although not always, require collateral to secure their loans. This collateral could be equipment, land or another asset of the company. This means that you risk valuable assets that you might lose should you fail to make a payment. In addition, you will not be able to lend from another lender using these assets as collateral, so you’d better be sure this debt is giving you enough runway.