There are so many advantages of debt financing that large businesses or startups could use to fund operations and increase growth. When considering the alternative ways to finance a company, debt financing is generally seen as an attractive option; and it refers to the ways that companies or businesses raise funds or capital by borrowing from individuals or organizations. Some common benefits of debt financing would be discussed below.
Table of Contents
- The major advantage of debt financing is the provision of capital
- Maintains ownership of the business
- You get tax deductions on interest payments
- Better repayment schedules than traditional bank loans
- You can turn equity into debt
- An advantage of debt financing over equity financing is that it is easier to obtain
- It protects against unfriendly shareholders actions
- You can raise more funds later
- Advantages of long-term debt financing
The major advantage of debt financing is the provision of capital
Companies can use borrowed money for many purposes. Debt financing gives entrepreneurs the capital they need to invest in their business, expand its operations and increase profits without diluting ownership or selling equity to investors. For startups, it also means that they do not have to come up with all the cash themselves, freeing them from restrictive loan covenants and giving them more control over their businesses. They can repay both principal and interest out of future cash flows generated by the business—a valuable advantage of debt financing because it enables them to maintain full ownership if things go wrong.
Maintains ownership of the business
One of the advantages of debt financing is that you retain ownership of your business.
Many small business owners are worried about giving up control of their company, especially if they have to bring in other investors who will own part of the business once the deal is done.
While debt financing doesn’t give you complete ownership, you can avoid dilution by securing debt against your assets or through personal guarantees. So even if your company loses the ability to make the promised payments, lenders aren’t able to take over your business as long as there’s sufficient value in what you own – for example, stocks, machinery, equipment, etc. As a result, bringing in debt financing gives you significantly more protection than equity financing does.
The main issue with venture capital is that it results in you giving up large chunks of your business in exchange for money. What’s more, if the business fails then the venture capitalists will come after you for all they can get in terms of assets and equity, leaving nothing behind for the company’s stakeholders. With debt financing, you are not handing over any part of your business.
You get tax deductions on interest payments
Debt financing gives you tax deductions on interest payments and can reduce your tax base by 28% of the interest on the debt. If you have a profitable and growing business, this will leave you with more after-tax profits to reinvest in your company. It also means that you do not have to pay income tax on any dividends paid out.
Better repayment schedules than traditional bank loans
You may be able to get better terms or more favorable repayment schedules than through traditional bank loans. For example, factoring accounts receivable (i.e., accounts bought by a factor) allows you to enjoy their float – that is, the time the money takes to come back from your clients/customers after it’s sent out, which can range anywhere between 10 and 45 days. Factoring this float time gives you access to working capital when needed most – when orders are placed, goods are made or services provided.
You can turn equity into debt
It allows you to borrow money without giving up any ownership of your company. You can convert existing equity capital into debt capital by issuing new bonds for the same amount as your equity. For example, if you own 100 shares in your company but need another $200,000 in working capital, instead of selling off some stock and diluting the number of shares held by current owners, you could issue $200k in new debt and keep all 100 shares.
An advantage of debt financing over equity financing is that it is easier to obtain
A good benefit of debt financing, especially to small businesses is that it is usually easier to obtain than equity financing. When you apply for a loan, banks will generally do basic checks on your business’s financials before offering their terms, of which small businesses are not favored. In debt financing, lenders seldom ask for extensive business plans, which is an advantage. Furthermore, given the competitive climate in today’s market, getting venture capital funding may be next to impossible for most small businesses – especially if you don’t have brilliant growth projections! Given this context, looking into alternative finance options such as crowdfunding would be the next best option for your business.
Debt financing can offer some protection against shareholder-unfriendly actions being taken against you e.g., a board that may have been packed with friends/family members of the original owner may try to take advantage of their position and start making decisions that favor them over the majority shareholders; an example would be if the board was to “borrow” money from equity account instead, there is less chance that these types of decisions will be allowed to go through without full consent from all shareholders.
You can raise more funds later
One of the advantages of debt financing is that it enables you to easily raise more funds later on down the line if your business is growing. Because equity financing results in investors/shareholders owning a part of your company, there’s no easy way for you to get back that ownership and if you need additional capital to expand, the only option left will be to issue new shares and dilute their percentage stakes in it – which they may not be too happy about!
Advantages of long-term debt financing
When you secure long-term debt financing, you have the advantage of fixed interest rates that translate into regular monthly repayments and high predictability. Another benefit of long-term debt financing is that it makes it easier for companies to budget because the fixed interest rates and the lower interest rates translate to affordable repayments which when consistent would increase the credit score of the company.
Dr. Brown is the founder of Jotscroll, he is a Medical Doctor, Entrepreneur, and author. Dr. Razi Brown holds a medical degree from the University of San Diego. He has invested in many startups and is currently working on his fifth book to be published in the upcoming year.