Debt financing is the most common form of small business financing. It involves borrowing funds from a lender and repaying the borrowed amount—plus interest—over a set period of time by means of regularly recurring payments. Common forms of debt financing include loans, lines of credit, and credit cards.
What Is Debt Financing?
Debt financing provides funding for your business through funds borrowed from a lender. This funding comes in various forms, but always involves an agreed-upon method of repayment. This type of financing is repaid in a series of payments and generally includes a percentage of interest due to the lender in addition to the funds borrowed.
How Debt Financing Works
With all forms of debt financing, you will apply to a lender for funding. The lender will then review your application to ensure that you meet its qualification requirements. If approved, you will be issued funding, typically by electronic transfer to your bank or directly to a vendor. You will then be required to make regular recurring payments until the debt is paid in full.
Some examples of debt financing include:
- Bank loans
- Personal loans
- Lines of credit
- Real estate loans
- Credit cards
- Guaranteed government loans like Small Business Administration (SBA) loans
Who Debt Financing Is Right For
Businesses that need a quick source of funding for working capital or other business needs will likely find debt financing to be an appealing option. Debt financing is also well suited for businesses that need to purchase equipment or real estate and for business owners that want to maintain complete ownership control of their companies.
Debt financing is a good fit for businesses that need funding for:
- Working capital: Businesses needing an influx of cash to fund immediate needs often rely on working capital loans to remain solvent
- Equipment or inventory purchases: Debt financing is often used to purchase equipment or finance inventory purchases
- Business expansion: As a business grows, its financing needs often do as well. Debt financing can provide businesses with funds for expansion
- Real estate purchase: Commercial real estate loans are a form of debt financing used to purchase or construct commercial property
The potential uses for debt financing for small businesses are virtually unlimited. However, some types are reserved for specific purposes. There are a variety of debt financing products available to small business owners.
8 Types of Debt Financing
Small business debt financing can come in many forms. The eight most common debt financing options for small businesses include SBA loans, short-term loans, business lines of credit, invoice financing, revenue-based financing, equipment financing, business credit cards, and merchant cash advances.
1. SBA Loans
SBA loans are long-term loans from a traditional lender that are partially guaranteed by the SBA. The SBA guarantee allows a lender to offer lower rates and longer terms than other long-term business loans. The rates for SBA loans typically fall between 7% and 11%, depending on the prime rate, with repayment terms of up to 25 years.
2. Short-term Loans
Short-term loans are easier to qualify for than SBA loans, and they typically have much faster funding times. In exchange for those benefits, short-term lenders also typically charge higher interest rates. Because most short-term loans are unsecured, meaning there is no collateral backing the loan, the risk to the lender is passed on through the higher interest rates.
3. Business Lines of Credit
A business line of credit is a form of business loan that allows you to borrow and repay funds over and over again. You only pay interest on the amount of funds you have borrowed, rather than on the full amount you have been approved for. Some of the best small business lines of credit can provide you funding in as little as two days.
4. Invoice Financing
Invoice financing, or accounts receivable (A/R) financing, providers will advance you a line of credit for a percentage of the amount owed to you from unpaid customer invoices. Invoice financing is offered by alternative lenders and is a great way to collect the value of your unpaid invoices in advance without having to wait for your customers to pay.
5. Revenue-based Financing
Revenue-based financing is a type of small business loan in which your monthly payment increases and decreases based on your business revenues. Lenders charge a fixed repayment amount, which generally ranges between 1.35x and 3x the amount borrowed. Because repayment of the loan is based on your revenues, the faster your revenue grows, the quicker you’ll repay the loan, and vice-versa
6. Equipment Financing
Equipment loans use the equipment you are purchasing as collateral for the loan. These loans are offered by online lenders or banks. Equipment loans can only be used for the purchase of equipment. Since the equipment is used as collateral to secure the loan, if you default, the lender can take possession of the equipment in lieu of the remaining debt owed.
Another way to finance equipment is through an equipment lease, which allows you to use the equipment with an opportunity to purchase it at the end of your lease term. While the upfront costs of an equipment lease are generally lower than with an equipment loan, the overall cost of financing is typically higher than with an equipment loan.
7. Business Credit Cards
Businesses with recurring working capital needs may find a small business credit card to be a relatively cost-effective source of debt financing. Many credit cards offer introductory periods at 0% annual percentage rate (APR), as well as cashback or rewards programs. These added incentives can be beneficial if your business regularly uses credit cards for working capital. A business credit card can be a simple source of funds for your immediate small business expenses.
8. Merchant Cash Advances
Merchant cash advances are an expensive form of funding that are typically used by borrowers unable to qualify for other forms of financing and should be used as a last resort. Your funding amount depends on the revenue your business earns from credit card transactions, and payments are made daily as a percentage of your credit card settlement.
Choosing the Best Debt Financing Option for Your Business
The best type of financing for your business will depend on your intended use of funds, how well you meet the qualification requirements and the amount of funding you need.
Determine the Amount of Financing You Need
Knowing the amount of financing will help determine which type of funding will best suit your business needs. Businesses that only require a small amount of funding to cover ongoing or recurring working capital needs may benefit from a business line of credit or a business credit card. Those needing larger amounts of funding would likely be better served by other options like a loan or invoice financing.
Review the Eligibility Requirements
Each lender has its own set of parameters for determining whether or not you qualify for its lending products. When comparing small business financing options, it’s important to understand the factors that lenders evaluate you on. Understanding these eligibility requirements will help you determine which loan products are best for your business’s situation.
Consider the Intended Use of Funds
When selecting financing, you will want to ensure that your intended use of the funds is allowable under the financing for which you are applying. Some loans have specified purposes for which they can be used. For example, an equipment loan can only be used to finance a piece of equipment and cannot be used for working capital. Other forms of financing, such as credit cards, are more flexible, and the use of funds is not limited to a certain need.
Compare the Costs of Financing Options
Different financing options charge different rates and fees. This can make understanding the true cost of capital confusing. The best way to compare the costs of financing is by comparing the APR. The APR standardizes the interest rate and fees into one rate to make comparing financing products easier.
Debt Financing Qualifications
The exact qualification requirements for debt financing vary not only based on the type of financing, but also by lender. In general, there are four qualification requirements to be aware of. Qualifying is most often based on your personal and business credit score, how long your business has been operational, the amount of annual revenue, and your business’s ability to repay the debt.
To ensure you will be able to repay your loan, lenders often require that your business revenues exceed a certain level before they are willing to provide you with debt financing. Each lender has its own requirements. In general, the greater your annual revenues are, the easier it is to meet this requirement.
Time in Business
In general, it is easier for more established businesses to obtain debt financing as many lenders set a minimum time-in-business requirement that must be met to qualify. Established businesses have more financing options available to them. If you run an established and profitable business and have good personal credit, you will be a good candidate for an SBA loan or bank loan, which are typically the least expensive forms of business financing.
It can be difficult to get funding for a startup business. Lenders that provide financing to startup businesses typically only offer small amounts of funding with high-interest rates. The best option for startup owners is to get a startup business loan or use personal assets like your retirement account.
Most lenders will have a minimum credit score requirement that you must meet to be considered eligible for funding. In general, there are financing options available for those with credit scores of 600 or greater. If you have a credit score of 680 or higher, it’s generally easier to qualify for most loans. Knowing your credit score will help determine which loan options you may be eligible for.
To qualify for debt financing, you must be able to prove to the lender that you have adequate repayment ability and can afford your loan payments. One way that lenders evaluate your repayment ability is by calculating your debt service coverage ratio (DSCR). Your DSCR is calculated by dividing your net operating income by the total of your debt and interest payments. Lenders typically prefer a DSCR of 1.25 or greater.
How to Apply for Debt Financing
The application process for most business loans can be started online through the lender’s website. For short-term financing options, the entire application process can typically be done online in a matter of minutes. For long-term loans, the application process is more daunting due to the amount of documentation required but can still be started from your lender’s website.
1. Complete the Application Form
In general, an application for any form of debt financing will require you to provide basic information about yourself as the business owner, as well as information about your business. This information will include such details as your name and the name of the business, the business address, your annual business revenue, and the amount and type of financing you are seeking.
2. Gather Supporting Business Documents
Depending on the loan type and the requirements of the specific lender you are working with, you may be required to submit additional documentation pertaining to your business along with the application. It is common for a lender to request key financial documents, licenses, and other information pertaining to your business operations.
Some of the business documents that you may be required to submit to the lender include:
- Detailed description of how you’ll use all funds
- Proof of business ownership
- Loan application history
- Business overview and history
- Current business financials
- Year-to-date profit and loss (P&L) statement
- Current year-to-date balance sheet
- Business tax returns
- Projected financial statements
- Business licenses
- Business leases
- Personal financial statement
- Personal tax returns
- Owner resume
3. Submit the Application Package to the Lender
Some lenders, especially online lenders, only require that you submit an online application that can be completed by answering basic questions about your business. You may need to provide other documentation to substantiate the information you provided, at the request of the lender.
Longer-term loans, like SBA loans or commercial real estate loans, will generally require that a significant amount of documentation be submitted with the application. Once you have gathered all of the required documents and completed the application, this becomes your application package, which is then submitted to the lender for review.
Debt Financing vs Equity Financing
When you think of business financing, you likely think of debt financing, which is a more traditional form of funding for businesses. Debt financing allows you to borrow funds from a lender and to repay those funds over a defined period of time. This is significantly different from equity funding, where funds are invested in the business with the promise of a future return.
Equity financing is a method of business financing wherein business owners receive funds in exchange for an equity stake in their business. This may occur through the sale of shares, or a promise of future equity payout by way of a convertible note, or simple agreement for future equity.
Some of the primary differences between debt financing vs equity financing are:
- Debt financing requires regularly recurring payments
- Debt financing has a predetermined payoff date
- Equity financing reduces your percentage of business ownership
- Equity financing does not affect your monthly cash flows
Pros & Cons of Debt Financing
Advantages of debt financing include the predictability of scheduled payments, the ability to retain ownership control, and the ease of accessing financing. Conversely, the disadvantages of debt financing include the fact that regular payments impact cash flow, the qualification requirements can be difficult to meet, and that it may impact your credit score.
Some advantages of debt financing include:
- Scheduled repayment: With debt financing, you know when your payments are due, and how much you need to repay. This makes budgeting for future business needs easier.
- Retain ownership control: Unlike equity financing, debt financing does not require that you give up any amount of ownership control.
- Easily accessible: Many different lenders offer debt financing through a number of different product types. Finding a lender and financing product that meets the needs of your business is far easier than obtaining equity financing.
Some disadvantages of debt financing include:
- Impact of cash flow: Because debt financing requires regular payments to repay the amount borrowed, there is a direct impact on the business’s monthly cash flow.
- Qualification requirements: Qualification requirements can make it challenging to procure debt financing as a startup as such business owners may need to resort to using personal loans for business for seed money.
- May affect your credit: If you miss payments on your loan, your credit may be impacted. However, repaying in-full and on-time can have a positive effect on your credit.
Alternatives to Debt Financing
Small business owners that aren’t interested in taking on additional debt may want to consider an alternative to debt financing. Most commonly, these alternatives are in the form of equity financing, such as crowdfunding, venture capital, and angel investor funding. Additionally, another alternative is using personal funds to invest in your business.
Crowdfunding utilizes small amounts of money contributed by many individuals to collaboratively fund your business. This collaboration is often facilitated through a crowdfunding site. In most cases, crowdfunding contributors are given something in return for their investment, whether it be equity, a promise to repay, or a reward. Crowdfunding is often utilized by startup businesses or those that are trying to expand into a new product line or market.
Venture capital is an equity financing option that can provide large sums of money to startups with high growth potential. In exchange for funding, venture capital investors will require an equity stake in your business. Venture capital is a good financing source for businesses requiring funding from $100,000 to many millions of dollars to scale. To apply for venture capital funding, you must find the right venture capital firm, pitch your company, and pass its due diligence process.
Using Personal Funds for Business
Small business owners that have personal or retirement savings may want to consider using personal funds to bootstrap their business expenses. Using your existing 401(k) to fund your business through a rollover for business startups (ROBS), allows you to use the money you already have to invest in your business.
By putting personal money into a business, there is no outside debt to repay, and you aren’t sacrificing ownership interest in the company. While this may not be an option available to all small business owners, those who have personal funds available should consider bootstrapping their business expenses before taking on additional debts.
Debt Financing Frequently Asked Questions (FAQs)
What are debt financing and equity financing?
Debt financing involves borrowing funds from a lender and repaying the amount borrowed over a specified repayment term with regular payments. Conversely, equity financing is provided in exchange for an equity stake in your business, wherein the funder becomes a partial owner of your business.
How do you get debt financing?
Debt financing is obtained through a bank or other lender. Each lender has its own qualification requirements. You apply for financing, and if approved, the lender provides you the funding that is then repaid in accordance with your financing agreement. The financing agreement dictates the repayment term, payment amount, and frequency of payments.
What is an example of debt financing?
Debt financing is a traditional form of financing and can come in many forms. The most common are loans and lines of credit. While the repayment terms may vary, with this type of financing, you borrow a specified amount and repay that amount plus interest to the lender over a defined repayment term.
Debt financing is commonly used by small businesses to fund their needs. Offered in many forms, including loans and lines of credit, debt financing allows businesses to purchase equipment, commercial real estate, and inventory, or to fund working capital needs. Qualification requirements vary by lender and type of financing.