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:
- Short-term loans are typically paid back within six to
18 months.
- Intermediate-term loans are paid back within three
years.
- 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.