Debt financing for startups means getting the borrowed funds. When a startup borrows money from outside at interest, it is called finance through debts. There are options for raising finance namely either through debt or equity or through a combination of both debt and equity. Thus debt financing and equity financing are major sources of finance for any business.
What are various Sources of Debt Financing?
There are a lot of debt financing instruments available in the market sources. Some of the most prominent are as under:
Bank loan/Business loan
Business Loans are provided by banks and financial institutions either with or without collateral security. Banks will often assess the individual financial situation of each company and offer loan sizes and interest rates accordingly.
Loans may be for short-term purposes or long-term purposes depending upon business requirements like working capital requirement or capital assets purchase or expansion of business etc.
This is a form of arrangement wherein companies can pay later for goods purchased now. Thus this is short-term debt financing. Also, no collateral security is required. Therefore, this is most convenient for small businesses and startups.
This is again a good way of debt financing. Here, the buyer mortgage the assets which it wants to purchase and make payments in fixed installments. This is suitable for those companies which have a higher credit rating in the market. They can easily purchase assets from banks and finance companies without mortgaging any additional assets.
Asset Based Lenders
These lenders are finance companies and provide money to companies for purchasing the assets on basis of mortgage of assets of company like stock, debtors, etc. Accordingly, it is very useful for companies with high inventory, debtors, etc.
Individuals or entities that purchase the bond then become creditors by loaning money to the business. A traditional bond certificate includes a principal value, a term by which repayment must be completed, and an interest rate.
Some banks offer the facility of factoring. Here, a business gets money upfront from a banker on basis of invoices raised to customers and doesn’t have to wait for customers to pay them. For this facility, some commission is charged by banker
Insurance companies act as a major source of finance for small companies. They provide two types of loans to businesses namely; mortgage loans and policy loans. A mortgage loan can be availed by mortgaging any asset of the company.
A company can take a loan from another company for financial requirements. While taking such a loan it has to comply with the provisions of the Companies Act.
Advantages of Debt financing
- Debt is a cheaper source of finance as compared to equity financing.
- It gets tax advantage as interest paid on debt is deductible as business expense whereas dividend paid to a shareholder is not a business deductible expense.
- The main reason that companies choose to finance through debt rather than equity is to preserve company ownership.
- In the case of insolvency, debt holders are safer than equity holders because debt holders have a priority claim on assets of the company where equity holders do not have any such priority or protection.
- Since debt has lesser risk, therefore, they are cheaper as compare to equity. Equity holders have higher returns as compare to debt.
Disadvantages of Debt Financing
- Debt may be a good option initially but as the company becomes overleveraged, the cost of raising debt becomes high.
- In case of more debt in a company, its Credit ratings also decrease.
- They need to ensure the business generates enough income to pay for regular installments of principal and interest.
- If the business should fail, the debt must still be repaid. Collateral to the lender puts their business assets at risk, and sometimes even their assets. Above all, they risk potential bankruptcy.
- In the case of debt financing, the borrower has a high risk as compared to the lender. Even if there is no profit in the company, still interest and principal amount need to be repaid.
Debt financing is a great source of financing. It serves long-term as well as short-term needs. The advantage of debt financing is that there is no need to share the ownership with anyone. Hence, the control remains with the promoters without any interference from outsiders.