Startup funding options: debt financing explained

Assuming debt can make or break a business. In fact, it’s one of the scariest things about taking an idea and turning it into a business. Majority fail. Crippling debt is a well known cause of a failed venture, yet lack of funding is also a cause. There are two ways to view debt. Debt can be viewed as poison to a business, sometimes even a necessary one. But debt financing can also be looked at as one of the cheapest financing methods around, if used strategically. Not all debt is bad debt. Debt, if used strategically, can reduce cost down the road.

Imagine a scenario where a silent partner invests $5000 into your business for a third of the company ($15000 valuation). The company nets $6000 after year one and $24000 after year two. This partner’s total share in the profits is $10000. The silent partner celebrates a hefty ROI whist you undermine your own share of the profits. All for what, no interest payments? Inevitably, if the entrepreneur grows in wisdom, they will buy the silent partner out. After all in this scenario, they aren’t apart of operations, and because of that, they present a dead weight on the business. Now the entrepreneur has to buy them out, in order to make use of or profit from their equity. How much cheaper would it have been to have just borrowed the $5000? Thus, if you are a control motivated entrepreneur, debt is very strategic, at times.

One of the overlooked advantages of debt is the reduced taxable net income from paying interest expense. Entrepreneur Magazine presents a strong argument for accepting debt. Many businesses operate with a line of credit because borrowing other people’s money can have a favorable return on investment. Even borrowing $10000 to fulfill a $30000 order with $2000 interest is the correct business decision, if a business doesn’t have the funds and no better loans are available (Lifshitz, 2014).

However, debt can introduce burdens on the company. Debt repayments may get in the way of paying other expenses, especially in the early months of a company. Also, debt isn’t as easy to acquire as it sounds. Many are denied loans for usually six common reasons (Fernandes, 2017). The worse your credit history, the costlier the loan. Therefore, if your credit is poor, this option isn’t as ideal for you.

Debt financing is viewed as the classic fundraising means outside of FFFs. For this reason many new entrepreneurs only consider it or strive to avoid it if at all possible. Entrepreneurs need to tackle the numbers to see if taking on any amount of debt is strategic for their business.


Raymond Fava is the founder of Startup Christ and the founder of EcoEats, Inc. EcoEats crafts exotic jerkies using unique flavors. To see their selection, click here.


References

Fernandes, P. (2017, October 5). 6 Factors That Keep You From Getting A Small Business Loan. Retrieved from Business News Daily: http://www.businessnewsdaily.com/6242-small-business-loan-mistakes-to-avoid.html

Lifshitz, E. (2014, December 4). 4 Reasons Why Borrowing Money Is Usually Better Than Giving Up Equity. Retrieved from Entrepreneur: https://www.entrepreneur.com/article/240191

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