Debt Financing Definition

Debt financing, in plain language, means borrowing money to run or grow a business. With debt financing, an entrepreneur borrows money and promises to pay back the principal (the amount borrowed) plus interest. The financing agreement specifies the amount of interest and a time schedule for repaying the debt. Once the entrepreneur pays back the principal and interest, they have no further obligation to the organization or individuals who loaned the money (often called the creditors). 

Companies often use debt funding for working capital (short-term expenses such as business operational costs and buying inventory) and for capital expenditures such as buying an expensive piece of machinery, buying a building, or acquiring other companies.

Types of Debt Financing

There are many types of debt financing available to small companies that qualify. Among them:

• Bank installment loans
• Lines of credit 
• Credit cards
• Vendor financing (trade credit)
• Equipment loans
• Real estate loans
• Factoring
• Inventory financing
• Merchant account financing
• Government-guaranteed loans (small business administration loan program)
• Loans from family and friends
• Bridge loans
• Cash flow loans (loans that are based on and paid off through the company’s cash flow)

Depending on circumstances, the loans made to a business will either be secured (requiring the owner to put up collateral) or unsecured (requiring no collateral).

Debt Financing vs. Equity Financing

The differences between debt financing and equity financing involve the obligation to repay the money and ownership of the business. 

Debt financing, no matter what form it takes, is basically a loan. The borrower is required to pay off the loan according to the terms of the loan agreement. The lender is entitled to nothing more than the return of their principle plus the agreed upon interest. The lender doesn’t own or control the business.

In contrast, equity financing is a way to raise money by selling ownership (shares) in a company. With equity financing, there’s no guarantee of repayment. Instead of getting a guaranteed payback of their investment, investors get a percentage of the business profits once it becomes profitable. Their percentage of profits will depend on numerous factors including the valuation of the company and percentage of the company’s shares they own. In addition, depending on the size of their investments, investors may become advisors to the company. They may also become involved with or even take over management decisions. 

Advantages of Debt Financing

Here are the reasons debt financing can be beneficial:

• It lets your business get funding without having to give up any ownership or control of the business.
• There are no additional payments once the debt is paid in full. 
• The business doesn’t have to share any future profits with the lender.
• Depending on circumstances and the amount needed, it might be faster and easier for an entrepreneur to get debt funding than it would be to get investors to give them money.
• The interest on a business loan is tax deductible.

Disadvantages of Debt Financing

• A business, and/or its individual owners, must have a good enough credit rating to be able to qualify for financing.
• The business owner needs the cash flow and discipline to repay the debt on the schedule specified in the lending agreement. If the agreement calls for monthly payments, the business owner has to make those payments even if there’s a seasonal downturn or a major customer makes a payment late.
• A business owner may have to put up collateral. Collateral is an asset of value (such as a home, a major piece of machinery, or other property) that a borrower can take away from the business owner or their company if they default on the loan.
• An entrepreneur may have to sign an agreement saying they will be personally responsible for paying off the debt if the company defaults. Signing such an agreement means the business owner will lose the LLC’s or corporation’s liability protection for that particular debt. If the business doesn’t pay, the business owner will have to pay it themselves out of their personal accounts.

Debt Financing Considerations

Factors that will determine if debt financing is the right option for a particular business’s funding needs include:

• Will the business be able to qualify for a loan or other types of debt financing?
• Will the company be able to repay the debt under the terms of the loan agreement?
• Are the owners willing to personally guarantee the debt if the lenders require it?
• Are the owners opposed to giving up any ownership rights in their business?

Recommended articles

• Business Financing Definition
• Equity Financing Definition
• Debtor Definition
• Business Loan Definition
• What Is a Short-Term Loan?
• Borrow Money When You Don’t Need It

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ZenBusiness loves helping entrepreneurs start a new business without the stress that usually accompanies that task. Their business formation services help make it easier to start an LLC or corporation in any state. Once the company is up and running, ZenBusiness offers a variety of products and services that make business compliance a snap, including ZenBusiness Money Pro. No matter what stage the business is in, ZenBusiness is ready and willing to assist.