Debt financing

The use of debt financing is preferable where entrepreneurs want access to finance for their business but do not wish to dilute shareholding in it by giving away equity to third parties in return for capital. As long as the entrepreneurs can meet their debt obligations, then their objective of financing the business and maintaining the existing shareholding structure can be realised. However, where entrepreneurs fail to meet their debt obligations, then the debt can become convertible into equity that creditors take up and thus making them shareholding partners in the business. The alternative may be penalties imposed by creditors, legal action against the borrower or even sale of the entrepreneur’s property to settle debts.

Debt comes in two broad forms which is long-term debt and short-term debt. Long-term debt tends to be more expensive [higher interest rate] than short-term debt because of uncertainty about the future and the opportunity cost of creditors foregoing present returns in exchange for higher future returns. Contrary to the belief held by many people is that debt is a bad thing that should be avoided, it is in fact, good for business in many ways such as:

  1. Debt can be cheaper than giving up equity.
  2. The fact that lenders are willing to finance a business suggests confidence in the business.
  3. An outstanding debt instils discipline and hard work in the business carrying debt in order to repay it.
  4. Interest on debt is tax deductible thus reducing tax liability.
  5. Debt mitigates risk by spreading it and sharing it with others [providers of debt].
  6. Debt can help the business grow faster than it would through reinvestment of savings of profits.

Important questions as far as debt is concerned are: how much of it should be acquired, from whom and at what cost? Carrying debt only becomes bad is when it is excessive amounts of it from the wrong sources and or at the wrong cost. Ideally, a business should have a healthy mix of debt and equity to unleash its potential.

Many businesses are started or taken to the next level of growth through personal loans and overdraft facilities extended by a bank.

Credit cards represent a loan from a financial institution that is often channelled towards business financing rather than personal expenditures. However, this is expensive money that should normally be used to manage short-term needs and not long-term business financing needs.

Home equity loans are given by financial institutions against the value a borrower’s home and are secured by the borrower’s home. In most cases, loans of up to 80% of the value of the property can be given depending also on whether or not there are outstanding mortgage payments and the credit scores of the borrowers.

Commercial business loans from financial institutions usually attract stringent requirements from entrepreneurs making them more practical options for development financing intended to take a business to the next level of growth rather than for first-time borrowers.

Factoring accounts receivable is not debt financing per se in the traditional sense of debt but rather a selling of debt to discount finance houses in return for cash immediately. The discount rate charged depends on the quality of the accounts receivable and the time span involved before the accounts receivable are due. For example, an entrepreneur can sell accounts receivable worth $100 000 to a discount house at a discount rate of 13.5%. Therefore, the entrepreneur will receive $86 500 immediately, rather than having to wait say up to 45 days to receive the full $100 000 that is owed to them by customers. The discount house assumes ownership of the debt and the risk of payment of the outstanding debt of $100 000. On collection of this amount, the discount house will realise a profit of $13 500.

Credit terms offered by suppliers amount to interest free loans that are extended to buyers providing that these are settled within agreed time frames. A good track-record of payment and a good relationship with suppliers can result in generous credit terms which have a positive impact on an entrepreneur’s business cash flows and general financial well-being.

In special circumstances, such as for example, where an entrepreneur is to become an exclusive distributor of a merchant’s product, the merchant may be willing help an entrepreneur set-up a business through direct cash advances that will be repaid over time.

Fellow entrepreneurs either acting individually or through some formal lending platform such as a business fund, may be willing to lend money to colleagues or club members at concessionary rates that are significantly lower than loans from commercial sources.

Peer-to-peer lending [P2P] is an online lending method for personal and business use. P2P lending by-passes the regular financial institutions and yet performs the same function as financial institutions of bringing lenders and borrowers together. At the centre of peer-to-peer lending is a company that acts as a broker and underwriter of the loans. There are many peer-to-peer lending platforms that offer varying amounts of money and have different target markets. Examples of peer-to-peer lenders include: Prosper Marketplace, Link, Circleback Lending, Rainfin, Ratesetter, landbay, Peerform, SoFi, Lending Club, Upstart and Funding Circle.

In the case of purchase order financing, an entrepreneur will have secured an order to supply goods or services to particular customers. However, for some reason, the entrepreneurs do not have the money to finance the fulfilment of the order. Therefore, they can approach a bank to provide order financing minus bank charges for financing the order. Entrepreneurs will usually make a down payment in order to reduce the amount to be paid in bank fees. Some of the common reasons behind an entrepreneur not having money to fulfil an order are that: (a.) the business may be growing too fast and (b.) the business may have large accounts receivable that have not yet become due or have not yet been collected. Purchase order financing is a form of asset backed financing in which the underlying asset acts as collateral for short or long-term financing. The underlying asset can be anything from inventory, equipment, machinery, real estate or accounts receivable.

Contract-based financing is often applied where an entrepreneur lacks capital and even skills to undertake production of commodities but own some basic infrastructure that can be used by a third party to expand their production capacity. Therefore, an entrepreneur can rent out their infrastructure and productive capacity to third parties that need them. In its most basic form, the contractor [the company giving out contracts] approaches the entrepreneurs or farmers and enters into an agreement with them to supply a product or commodity meeting certain defined specifications. The contractor will supply the specifications, the training, the inputs or raw materials, the technical support and the supervision. In return, the entrepreneurs undertake to supply their entire production to the contractor at an agreed price that is set before production. At the end of the production cycle, the entrepreneurs will hand over the entire production to the contractor. The contractor in turn will deduct his expenses [input costs, training and administration] and the entrepreneurs will remain with the balance as their profit. While it is not perfect, contract-based financing can be a good way to raise money for entrepreneurs that are starting with nothing but some basic infrastructure that they own. Repeating the contract financing process a few times can put entrepreneurs in a position where they have enough resources and finance to develop their own businesses.

Warehouse financing also known as warehouse receipt financing is another asset-based financing method. This form of debt financing is more suited for agricultural sector financing than any other sector. Warehouse financing is used where entrepreneurs wish to take advantage of a future increase in the price of a commodity that they have produced or where they wish to stock up a commodity to reach a certain volume before it is sold. For these reasons, the current production stocks are warehoused. In the meantime, working capital needs will be financed through a loan while the entrepreneurs wait for the required condition to be materialise. The loan is secured by the merchandise that has been warehoused.

Therefore, it is important to make an accurate determination financial needs of a business based on actual costs, good estimates and good forecasts. Entrepreneurs should seek the right size of funding, with a reasonable buffer just in case.