Debt Financing Explained
Debt financing translates to a company raising funds for working capital. The security put forth is in the form of collateral that can be issued as; bills, selling bonds, and notes to institutional/individual investors.
The security assures creditors their funds will be repaid in principal and interests accrued. Debt finance factors in both secured and unsecured loans. Should there be a loan default, the collateral gets forfeited.
So what is debt financing? This is a financing process where a firm/organization is granted a loan, and in return, it promises to repay the loan and interests agreed upon.
Most start-up companies refer to debt finance as a convertible note. These companies rely on debt financing as cost-effective ways to generate seed money.
The financing process is way cheaper in terms of paying legal bills as opposed to raising finance through a priced stock round.
Debt financing requires companies/startups to set a “cap” note value as opposed to setting a final valuation.
In a nutshell, if a Cap stands at $1M, and the company lives up to its expectations, the next value comes in at $20M, the initial note investors pour their monies in at $1M.
Organizations/institutions sourcing for debt financing is required to set a discount rate. A majority note discount rates come in at 20 percent.
Why is the Discount Necessary?
To rally up investors and make it worth their while discounts are put in place to encourage them to invest in the convertible note.
During the next financing round, the initial investors get a 20 percent discount and qualify for the wholesome interest rate. For debt financing, the interest rates margins fall in between 4 and 6 percent.
Let’s look into the different types of collateral/security you can guarantee potential lenders:
Securities: publicly listed companies are authorized to float stocks and bonds which become the collateral against the loan.
Endorsers: they sign an agreement to guarantee the loan, in some situations, endorsers part with a form of collateral.
Insurance Policies: In most instances, insurance policies act as collateral covering upwards of 95 percent of the policy’s cash value.
Guarantors: They sign agreements clarifying and committing themselves to guarantee the loan payment.
Display merchandise: Vehicles, office or home electronic equipment and furniture are registered as “floor planning” collateral used for securing loans.
Equipment: All the material fronted as collateral covers 60-65 percent of their total value.
Lease payments: the lease gets assigned to the lender, in instances the latter holds a mortgage on the property you wish to lease.
Real estate: whether commercial or private, real estate covers up to 90 percent of its assessed value to cover the loan.
Chattel mortgage: the action comes into effect in instances where equipment acts as collateral. The lender makes the loan based on a lesser value than that of the equipment and holds the mortgage until the loan gets repaid in full.
Co-makers: these are the principals charged with repaying the loan.
Certificate of deposit: also known as a savings account, they can be used as collateral for securing a loan.
Warehouse inventory: the inventory guarantees upwards of 50 percent of the loan amount only.
Accounts receivable: an action enabling banks to advance 65-80 percent of the receivable’s value the instant the merchandise gets shipped.
Unsecured Loan Debt Financing
Unsecured loans are given to organizations/companies with an excellent credit reputation. Unsecured loans are extended to individuals up to several thousand dollars or more if your relationship with the bank is stable.
Unfortunately, unsecured loan debts are short-term and are given with extremely high rates. A significant number of lenders are conservative and rarely issue out unsecured loans.
The only way to get such loan amounts is if only if the institution/company has done a lot of business with the financier in the past and has always delivered beyond expectation.
The loan is so controversial that regardless of how much business has been done between the firm and the lender, collateral might be guaranteed to mitigate the current economic conditions.
In some instances financiers allow cosigners to take up the legal obligation of fulfilling the debt should the company/institution default.
Most unsecured loans are given out as; personal loans, credit cards loans, and student loans. The loans are issued under the following circumstances:
Consolidated loans: paying off a signature loan or credit card loan from a financier is considered as an unsecured loan.
Revolving loan: an unsecured loan that comes with a credit limit which can be spent, repaid and spent again. Such investments include a line of credit and credit cards.
Term loan: An unsecured loan that borrowers repay in stipulated installments until when the loan is paid in full by the end of its term. Financial data updated in 2018 shows how the unsecured loan market is growing in leaps and bounds.
Many companies, as well as individuals, are opting for unsecured loans thanks to financial technology advancement. For both secured and unsecured loans, a lot of debt is subject to repayment periods. These periods fall into three sub-categories namely:
- Short-term loans: the debt should be repaid within 6 to 18 months
- Intermediate-term loans: the debt should be paid in full within 3 years
- Long-term loans: Debt is paid from the business’s cash flow in no more than 5 years.
Family and Friends
Family and friends mostly start a significant source of debt financing for new businesses (startups) as opposed to commercial lenders.
Legal practitioners advise startups to have a legal contract drawn up when borrowing money from relatives or friends.
It’s rather unfortunate that a lot of entrepreneurs borrow funds informally from family and friends. Mostly the terms are negotiated verbally and are never entered into a contract. Having people who know you fund your business is always tricky.
Some will want to interfere “help” you run the business when they think that you’re slacking and they risk losing their investment. To eradicate such short-comings, having a written contract is vital.
However, in some states, the laws grant investors the right to voice their opinion through voting rights and this could lead to conflict.
Before settling for loans given by either friends or family, its important to talk through the risks with an attorney to know where things stand.
Credit Card Financing
Most startups opt to source capital through credit cards. The avenue is increasingly becoming popular despite the high-interest rates pegged to this type of financing.
Credit cards are a gateway to gaining access to several thousand dollars fast without the headache that comes with filling and signing paperwork. They’re a tremendous financial source for startups that can repay the debt in good time.
Timely payments cap the additional interests that add on to the debt either daily or every week.
How To Finance A Business Using Credit Cards
For a startup that has 3 credit cards with each having a line of $6,000, and wish to finance the business to a tune of $10,000, you can take up cash advancement on every card and get the business rolling.
If the business proves profitable within six months, you can use the financial statements to go to a lending institution and get a loan for $12,000 with a 10 percent interest rate.
Use the funds sourced from the lender to pay off the credit card loans and interests (Some go as high as 18-20 percent in annual rates). Within the coming 6-12 months, you can use your profits to pay off the financier’s loan, and you’ll be in the clear.
Loans issued to SMEs are pegged at a higher cost than the regular prime rate loans granted to companies that have better relationships with financiers. SMEs end up paying between 1-3 percent points above the top rate.
A lot of startups and small-businesses spend most of their time searching for loans with reasonable terms as opposed to factoring the interest rates. It’s wise to look at both and weigh the options.
Financial institutions also deny SMEs loans when they are experiencing a seasonal slump, temporary decline or have rapid sales growth.
Moreover, businesses that are in the “high debt-to-equity ratio (highly leveraged) bracket go through a lot of difficulties before they get funding.
Is Debt Financing Viable?
Debt financing is an expensive and risky way companies/organizations and individuals use to raise funds. The business ends up hiring an investment banker charged with structuring huge loans in systematic ways.
The only time debt financing is viable is when the interest rates are low, and the returns are high. Businesses and organizations undertake debt financing because they’re are not needed to pump in their capital.
However, without proper planning and structuring, accruing too much debt is a huge risk. In-house and invited financial auditors are called in to set the level of debt financing ( debt-to-ratio) the company should obtain.
Before sourcing for debt financing, small businesses and startup should study and weigh all other options.
If debt financing is the only way to go, then they have to brace themselves for overworking and sleepless nights until they can repay the funding in full!