There are several ways to fund a start-up or bring capital into a growing company. Many looking to start a business try to avoid accumulating any more debt than necessary and choose to use their own money to fund their new venture. Others look to leverage their company through equity financing, hoping to reduce their borrowing costs in exchange for granting their investor/lenders an ownership interest in the business. While either of these approaches can make sense in the right situation, growing businesses can also benefit from an alternative approach: debt financing. Funding part of your financing strategy with debt can give you a short-term boost that leaves you more room to grow.
How Debt Financing Works
Simply put, debt financing means taking loans or cash advances to provide capital needed to operate your business. The traditional source for this type of funding came through bank loans, but private finance companies, private investors or even government entities can also put up funds to offer or subsidize business loans and capital advances. The cost of debt financing is the sum you pay in addition to repaying what you've borrowed. The way you go about debt financing, the amount you can borrow, and the finance cost you can expect to pay depend on a combination of credit history--both your business and your personal credit--and the value the lender places on your business and their confidence in your ability to succeed.
Potential Risks of Debt Financing
Borrowing money for your company brings some risks, of course. You have to repay the funds on a set schedule, one determined at the time you borrow. If your revenues do not match expectations, you may find yourself scrambling to keep up. If too much of your funding comes through debt, you will likely take longer to become profitable, and have trouble gaining access to more funds when you need them.
On the other hand, debt financing does offer important advantages over equity financing and self-funding your business. If you borrow responsibly and carefully, it gives you the ability to grow more quickly while increasing and preserving your net worth.
Debt financing does cost you through interest payments. Still, even that interest can come back to you in the form of tax deductions. The U.S. government, to encourage business investment, allows you to take interest on business debt as a deduction. For some companies, this can help cut into the tax bill that a profitable year would create. The cost of your debt goes, in part, right back to your bottom line.
The Danger of Self-Funding
No doubt it can be tempting to use to use personal funds to start or help operate a business. If you take money from yourself, you avoid borrowing costs. But, you sacrifice some of your own safety net and lose out on the interest deduction. More importantly, by mixing personal funds in your business, you risk becoming personally liable for business debts. Even if you're incorporated, when personal funds are blended with your business assets, it becomes harder to claim the business is separate. A lawsuit against your company may then seek out your personal assets.
Are You Growing?
Debt financing gives you distinct advantages over equity funding as well. Borrowing against equity may feel safer, but for growing companies, equity financing will cost more in the long run. In essence, debt financing is a bet on yourself to succeed, while equity financing gives over the growth you achieve for money today.
For example, if you give a 10% stake in your company in exchange for $100,000, it can feel like a windfall. If your company is worth $5 million in two years, though, that investor suddenly owns $500,000 worth of your company, whereas borrowing $100,000 as debt would have you owing just the $100,000, plus interest--while retaining full ownership of your company's value.
Part of the Mix
With all these advantages, you still need to be careful not to over-extend. When you fund your startup or growth plans entirely with debt, it diminishes the value of your business. Beyond that, it makes it difficult to borrow more in an emergency, or to get out of the burden of your debt if your revenues don't match expectations.
Entrepreneurship provides one of the purest balances between risk and reward. Grand success stories and spectacular failures both come from the small business model. Debt financing is just one example of the myriad ways this plays out. Borrowing too much can cut too deeply into your revenues, while fear of borrowing enough can choke off your growth before you begin. At Kenmore Capital we can help you balance responsible debt financing with other funding mechanisms, using strategies that both protect and build your dream business. Set up a Discovery Session with us today and see how to fund your business the right way.