Debt Finance for Start Ups: Better Alternative to Equity Financing

Debt Finance for Start Ups: Better Alternative to Equity Financing

There are various funding sources to provide an injection of cash to your business but each of them has their own advantages and drawbacks and not all of them will be suitable. Here comes in debt finance for start ups.

 

Equity financing is the most popular way to raise funds as you can get a large capital that is not feasible with funding from banks and private lenders but you will have to share a certain percentage of profits with them. In other words, they will act like a board of directors and participate in decision-making.

 

However, it sounds scarier to many entrepreneurs. It is quite obvious to be anxious when it comes to sharing profits with tem and involving them in decision-making. It is a better alternative than equity financing as it acts like another loan that you are to pay back along with the interest.

 

An investor will lend you money after pursuing your business growth plan for a certain period of time at a specific interest rate. This is a kind of bond. An investor earns money in the form of interest and they will be undoubtedly high as it is riskier to invest in a business that has not just started off the ground.

 

With debt financing an investor will not get the right in the decision-making process. They will not be a part of the board of directors. They will get money over time in installments that go toward both the principal and interest.

 

What are the Debt Financing Options?

 

Debt financing has two types and it depends on the requirement of your business. Here are the types:

 

Long Term Loan

 

Your startup may need a lot of money when you need infrastructure, equipment, inventory, and a lot of other things to start your business. You will need a lot of money to invest in the initial capital of your business. You must have some savings to throw at it. For instance, if you do not have a penny to invest in your business, no investor will lend you money.

 

It will clearly indicate that you are completely dependent on external funding and you may default. An investor will evaluate the worth of your company’s assets in order to determine how much they can lend you because these loans are secured in nature.

 

An investor will not straightaway lend money you expect. They cannot pay more than the worth of the asset. They will also impose certain terms and conditions that you must abide by.

 

Short Term Loan

 

If you want to increase capital you may need a long term loan, but you may also need money to finance other costs to keep the ball rolling. For instance, you may need to fund salaries, rent, raw material, and building and equipment maintenance.

 

The term of these loans is not too big, so interest rates will be lower. You may not need to secure the debt against your high-value asset. Before you choose debt financing you need to carefully analyze your needs. Because debt financing is not inexpensive at all because it involves a huge risk in a startup, try to have all your other debts settled.

 

For instance, you must not have any outstanding small debt like short term payday loans from direct lenders or credit card bills. Any outstanding debt can pull your credit score and call your creditworthiness into question.

 

What are the Benefits and Drawbacks of Debt Finance for Start Ups?

 

Here are the benefits and drawbacks of this type of funding. Weigh up everything so you do rue in the end.

 

Benefits Drawbacks
An investor cannot get the right in decision-making process. It is just a certificate of lending not a certificate of share. You will have to pay back the debt regardless of your business profitability. Your business losses cannot be an excuse to miss repayments.
You can borrow based on your needs so it provides a constant flow of money to hit the ground running. If you are borrowing a large amount of money to fund your capital, you will have to secure it against a valuable asset. You may lose it in case you make a default.
You are absolutely free to use the money. Unlike equity financing it is not restricted to specific uses and no investor can interfere. If you are borrowing a small amount of money, you will end up paying high interest rates. This is because they are not secured.
You can use debt financing at any stage. Even if you are an established business and you need money for investing in a big project, you can consider this alternative. An investor will lend you money after evaluating the value of your assets. You cannot borrow more money than that because it is riskier not just for an investor but for you as well.
Interest rates will be fixed, which means payments will not fluctuate if your business profits go up and down. You can lose the possession of the asset in case you make a default. This may interrupt the smooth functioning of your business down the line.
Debt funding is more affordable than equity financing. Compared to other funding alternatives, it can be riskier.

 

How can you raise Funds through Debt Financing?

 

You will have to do proper research to make a list of investors who are looking to supply funds to your business. Most of the investors invest money in startups in order to get share in the profits and become a board of directors. You will have to pick the one that is happy to get a return in the form of interest.

 

Make a business plan that leaves a good impression on your investors. Your investors will likely see the prospect of growth in your business and the value of assets you hold so they can determine if it is worth lending money to your business.

 

Market research is also crucial so you can raise funds at affordable interest rates. Every investor has a different outlook to perceive applications and your repaying capacity. While some may charge high interest rates while others may charge more affordable interest rates.

 

Comparison is a must so you get money from a reputed and trustworthy investor that lends money at lower rates. Debt financing may not be a good option when you have already taken on debt, for instance, you can take out debt consolidation loans for bad credit with direct lenders.

 

Summary

 

Debt finance for start ups can be a better alternative than equity financing as you do not have to let an investor share a certain percentage of profits and join a team of board of directors. Unlike equity financing, you can use funds for any purpose.

However, under some circumstances they can be secured. You will likely lose security if you fail to repay the debt. The security you put in will be higher worth than the amount you are borrowing.

Though debt financing can be more affordable than equity financing, there are some other sources as well. Weigh them up and then make a decision. Choose the funding source that best meets your needs.

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