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Debt Financing

Definition: A method of financing in which a company receives a loan and gives its promise to repay the loan

Debt financing includes both secured and unsecured loans. Security involves a form of collateral as an assurance the loan will be repaid. If the debtor defaults on the loan, that collateral is forfeited to satisfy payment of the debt. Most lenders will ask for some sort of security on a loan. Few, if any, will lend you money based on your name or idea alone.

Here are some types of security you can offer a lender:

  • Guarantors sign an agreement stating they'll guarantee the payment of the loan.
  • Endorsers are the same as guarantors except for being required, in some cases, to post some sort of collateral.
  • Co-makers are in effect principals, who are responsible for payment of the loan.
  • Accounts receivable allow the bank to advance 65 to 80 percent of the receivables' value just as soon as the goods are shipped.
  • Equipment provides 60 to 65 percent of its value as collateral for a loan.
  • Securities allow publicly held companies to offer stocks and bonds as collateral for repaying a loan.
  • Real estate, either commercial or private, can be counted on for up to 90 percent of its assessed value.
  • Savings accounts or certificate of deposit can also be used to secure a loan.
  • Chattel mortgage applies when equipment is used as collateral--the lender makes a loan based on something less than the equipment's present value and holds a mortgage on it until the loan's repaid.
  • Insurance policies can be considered collateral for up to 95 percent of the policy's cash value.
  • Warehouse inventory typically secures up to only 50 percent of the loan.
  • Display merchandise such as furniture, cars and home electronic equipment can be used to secure loans through a method known as "floor planning."
  • Lease payments can be assigned to the lender, if the lender you're approaching for a loan holds the mortgage on property you're trying to lease.

You can also try to acquire debt financing through an unsecured loan. In this type of loan, your credit reputation is the only security the lender will accept. You may receive a personal loan for several thousand dollars--or more--if you have a good relationship with the bank. But these are usually short-term loans with very high rates of interest.

Most outside lenders are very conservative and are unlikely to provide an unsecured loan unless you've done a tremendous amount of business with them in the past and have performed above expectations. Even if you do have this type of relationship with a lender, you may still be asked to post collateral on a loan due to economic conditions or your present financial condition.

In addition to secured or unsecured loans, most debt will be subject to a repayment period. There are three types of repayment terms:

  1. Short-term loans are typically paid back within six to 18 months.
  2. Intermediate-term loans are paid back within three years.
  3. Long-term loans are paid back from the cash flow of the business in five years or less.

The most common source of debt financing for startups often isn't a commercial lending institution, but family and friends. When borrowing money from your relatives or friends, have your attorney draw up legal papers dictating the terms of the loan. Why? Because too many entrepreneurs borrow money from family and friends on an informal basis. The terms of the loan have been verbalized but not written down in a contract.

Lending money can be tricky for people who can't view the transaction at arm's length; if they don't feel you're running your business correctly, they might step in and interfere with your operations. In some cases, you can't prevent this, even with a written contract, because many state laws guarantee voting rights to an individual who has invested money in a business. This can, and has, created a lot of hard feelings. Make sure to check with your attorney before accepting any loans from friends or family.

One of the most popular avenues of obtaining startup capital is credit cards. Although most charge high interest rates, credit cards provide a way to get several thousand dollars quickly without the hassle of paperwork, as long as you don't overextend your ability to pay back the money in a timely fashion. Interest payments on credit-card debt adds up quickly.

If you have three credit cards with a credit line of $5,000 on each card and you want to start a small business that you think will require approximately $8,000, you could take a cash advance on each card and start that business. Within six months, if you build up a profitable business and approach your local bank for a $10,000 loan at about 10 percent interest, you could use this money to pay off your credit-card balances (which most likely have 18-percent annual rates). After another six months, you could pay off the bank loan of $10,000.

A small-business loan usually costs a little more than a loan at the regular prime rate, which is the rate that banks charge their most favored customers. Small businesses usually pay one to three percentage points above that prime rate. Most small-business owners are more concerned with finding the right loan at the right terms than with the current interest rate. Be sure to shop around.

Banks tend to shy away from small companies experiencing rapid sales growth, a temporary decline or a seasonal slump. In addition, firms that are already highly leveraged (a high debt-to-equity ratio) will usually have a hard time getting more bank funding.

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