What You Should Know About Debt Financing
How much does it cost to start a business, and where does that money come from? The answer to these crucial startup questions varies drastically across a new company’s industry, location, and structure. For a service company, like a new landscaping business, the cost could be relatively low to get started - you just need the right tools. For a software company, the cost will depend on the complexity of the software and the minimum viable product you plan to sell. For a new restaurant, the cost could be much higher due to the necessity of having a physical location.
With so many variables, it’s safe to say that not everyone will be able to pay for their new company through their personal savings alone. Instead, you’ll need to consider alternate forms of funding. Luckily, bootstrapping isn’t your only option when it comes to starting up. If you’re ready to take the leap into small business, you may want to consider debt financing.
What is Debt Financing?
Debt financing, alongside bootstrapping and equity financing, is one of the most common ways used to get a business off the ground. Unlike many business terms, this one doesn’t feel like rocket finance to understand. Debt financing simply means that you’re choosing to use loans to get your business off the ground.
Just like any other loan in your life, you’ll apply, receive a certain amount of money, and pay it back within a certain timeline with a certain amount of interest. Simple, right?
Well, that’s debatable. There are several options to consider when it comes to debt financing. Since loans turn your new business project into a long-term, serious commitment, you should know your options.
How to Use Loans to Start a Company
Family and Friends
Family and friends are among the most common source of early-stage financing for small businesses. Since this is the group of people most intimately familiar with your hopes and goals, they make a great source of financial support alongside their emotional support for your new venture. It could be uncomfortable or even risky for your personal relationships to ask for money, but you should remember that it’s not uncommon. You should consider asking for funds if you have evidence that your idea is strong and you can return the money later on.
Starting with friends and family has several benefits. First, they’re more likely to listen to your pitch. If you ask nicely, you may even get feedback from them to help you move forward. Second, using money from your friends and family gives you the freedom to work on a relaxed timeline if they agree to a longer payback period than a bank would.
If you decide to ask family and friends for loans, you should be careful on two fronts. First, be sure to treat your network and their money as professionally as you would treat an investor. Being careless in this situation could put your relationships at risk. Second, be sure to make the distinction between a loan and a gift. Having the paperwork in order for both cases is crucial to protecting your business.
Personal Bank Loan
You could use a personal loan as a source of funds for your business. If you choose to do so, the bank will look into your personal finances to make a decision about allocating the money (not your business’ finances). Typically, the bank will give you flexibility on how to spend the money and may not ask for collateral.
Since it can be challenging to secure a business loan as a new or small company, this could be a helpful route for you. In many cases, it could be easier and cheaper. There are two options: a line of credit that allows flexible borrowing a variable rate, or a term loan for a specific amount of money at a fixed rate of interest (repaid evenly over time). Wile a credit line allows you to finance operations and get money when you need it, a term loan helps could be better to make a large purchase upfront.
In both cases, remember that banks could take some time to make a decision on your application, and they could reject your application altogether.
Business Bank Loan
Instead of using your personal finances to secure a loan, you could use your company’s reputation and financial documents to get approval. If you secure a business bank loan, you’ll likely receive lower interest rates than other debt financing sources. However, you may be required to show how you plan to spend the money you are given.
For a business bank loan, you’ll likely need to provide a collateral guarantee. In the case of brand new corporations, the bank can’t use the owner’s past credit history, so collateral will be an especially important factor. This could mean putting a certain amount of cash into a deposit account until you demonstrate your ability to repay your debt. Yes, this seems counterintuitive at first - you have to pay money to borrow money. But banks want to be assured you will not walk out on your debt obligation without them being able to recover some or all of the money they lent you.
How to Apply for a Business Bank Loan
You’ll start the process by filling out the required application form. Although forms vary, you can be sure they’ll ask you for your reasons behind applying, your intended use of the funds, any other business debt you have, your personal background, and information about a team. Even after all of these details, the bank could still ask you for additional information.
Before you get started, check in with your bank and ask for a list of what they will ask. If needed, prepare more information and documents, like financial statements, legal documents, your business plan, and financial projections.
Banks ask for these details to ensure that funds are allocated for a sound business purpose and to assess the extent to which you can be trusted. Similar to every other loan application, remember that this process can take time, and you could still be rejected a the end of the process.
SBA loan programs are administrated by the US Small Business Administration. The administration offers a few financing options for very specific purposes, and you’ll need to qualify before receiving your funding.
As the most common of the SBA’s loan programs, 7(a) Loans are meant to help start or expand a company with a maximum of $5 million.
504 Fixed Assets Financing
The 504 Fixed Assets program is designed to help small businesses who are looking to make a major purchase of fixed assets, like real estate or equipment.
A MicroLoan from the SBA can provide up to $50,000. The program is targeted to small businesses who have no or very little business credit history.
Disaster Loan Program
The SBA provides Disaster Loans to help in the recovery of a declared disaster. The approval rate for these is very low and the funds are difficult to receive.
Are You Ready to Take a Loan?
As with every decision in business, you should think carefully before taking out a loan. While starting a business is an exciting, fun experience, taking your first loan out should mean that you’re in it for the long-haul.
Be sure to test your ideas before getting to this stage. Will your service meet the needs of your target audience? Will you have customers coming into your new store? Does your town want a new coffee shop? When you’re sure the answer is yes, you’ll be ready to jump into debt financing.