What Is Debt Financing?

If you’re starting a new business, you need capital to fund rent, utilities, software subscriptions, salaries, and the many other expenses required to open your doors. Whether you’re a small business or an established company planning your next big move, there are many options out there for securing startup funding.

Debt financing is one of the most popular financing options for businesses. With this option, you take on the burden of interest and debt while retaining full ownership and control over your business. But what exactly is debt financing, and how can it benefit—or potentially burden—your business?

In this article, we’ll cover what debt financing is, cover some different types of debt financing, and help you gauge whether or not it’s the right fit for your business.

What Is Debt Financing?

With debt financing, a business gets funding by borrowing money that it repays over time with interest added. Unlike equity financing, where you give up a slice of your business’s control and profits, debt financing doesn’t dilute your ownership. That makes debt financing a more attractive option to startups that need cash now but plan to experience explosive growth.

Types of debt financing for startups include bank loans, lines of credit, and bonds. Regardless of where you secure the funding, the principle of borrowing money now and repaying it later allows you to plan your financial future with more predictability.

However, it’s important to keep in mind that every lender is different. It’s crucial to shop around for debt financing and weigh the payment terms, interest rates, and other factors to determine which is best for your business. Some debt financing deals put undue stress on new companies, so consider your financing options before accepting debt and the interest that comes with it.

How Does Debt Financing Work?

With debt financing, you borrow money from a lender and repay it over a specific timeframe with interest. But how does debt financing work in practice? The process typically follows these steps:

1. Shop around: Debt financing is available through traditional bank loans, bonds, lines of credit, and even the Small Business Administration (SBA). Before making a decision, compare at least three options. You’ll likely need to provide financial statements and a business plan for a quote.

2. Get a loan: Once you’ve chosen a lender, start the debt financing process. The lender assesses the business’s creditworthiness and determines the loan terms, including interest rates, the repayment period, and any collateral requirements. If you have a startup, you’ll likely need to provide collateral to reduce the lender’s risk. The upside is that some lenders will cut interest rates if you offer collateral.

3. Cover expenses: After you receive the funds from the lender, use the debt financing to cover expenses or invest in growth.

4. Pay it back: The downside to debt financing is that it creates a liability on your balance sheet. While the lender provided a minimum repayment plan, this plan maximizes interest payments. The faster you pay off your loan, the less you’ll pay in interest. Manage your expenses carefully to always cover the minimum payment (plus extra, if possible) to avoid penalties.

Long-Term vs. Short-Term Debt Financing

Some businesses need short-term funds to cover minor cash flow issues, while others need long-term funding solutions. Weigh the differences between these two options to make an informed decision for your company.

Long-Term Debt Financing

With long-term financing, you repay the loan over a longer period of time, ranging from five to 30 years. This type of financing is ideal for paying off big investments, such as property or equipment purchases.

Long-term debt financing spreads the repayment over many years, reducing the burden on today’s cash flow. Most long-term options also include fixed rates, giving you more predictability over time. Unfortunately, the longer timeline means you’ll likely pay more in interest if you only pay the minimum amount. You also have to plan for regular debt payments in your monthly budget, which can hinder your ability to save.

Short-Term Debt Financing

Short-term financing charges less interest, but you have to repay the funds within a year or less. Short-term debt financing amounts are often lower, allowing you to manage cash flow, buy inventory, or bridge the gap after unexpected expenses.

The upside of short-term debt financing is that lenders offer quick approvals with little paperwork. However, they come with higher interest rates than long-term loans, and the need for quick repayment can strain cash flow for new businesses.

Types of Debt Financing

Debt financing is a popular way to finance a small business, and there are many ways to access this financing. Whether through a traditional bank or invoice factoring, understanding your options will help you choose the best fit for your business.

Traditional Bank Loans

With a traditional bank loan, you borrow a lump sum from a bank. The loan will have either a fixed or variable interest rate, and you’ll repay it over a predetermined period of time. These loans are ideal if you need substantial capital for expansion, equipment purchases, or other long-term investments. However, banks are risk-averse, so you need a strong credit history and collateral to secure this type of debt.

Bond Issues

Bond issues are a form of debt financing where businesses raise capital by issuing bonds to investors. With this option, you repay the principal amount of the loan, plus interest at fixed points, until the bond matures. Smaller businesses usually don’t issue bonds, but they’re a great fit for larger companies that need to manage long-term debt.

SBA Loans

The Small Business Administration (SBA) offers specialized debt financing for qualifying small businesses. The upside is that these loans usually have lower interest rates and longer repayment terms than bank loans. Still, SBA loans require a lot of paperwork and a proven track record, so not all small businesses can actually qualify for them.

Lines of Credit

A line of credit is a form of debt financing where you borrow funds up to a predetermined limit as needed. Instead of receiving a lump sum upfront, you only borrow what you need and pay interest on what you use. A line of credit is ideal if you want to finance short-term needs or unexpected expenses without applying for a loan each time.

Asset-Based Lending

With asset-based lending, you use assets like inventory, equipment, or accounts receivables as collateral. The upside is that asset-based lending gives businesses quick access to cash, even with limited credit history.

However, there’s always the risk of losing collateral if you fail to repay the loan.

Invoice Factoring

Invoice factoring is a different type of financing where you sell your unpaid invoices to a factoring company. This option allows you to access immediate cash based on the value of outstanding invoices instead of waiting for customers to pay.

Invoice factoring is particularly useful for managing cash flow in industries with long payment cycles, providing a quick and reliable way to fund day-to-day operations.

Advantages and Disadvantages of Debt Financing

Debt financing can be a game changer for new businesses, but it has its pros and cons. Understand the benefits and disadvantages of debt financing before taking out a loan to fund your business.

Debt Financing vs. Equity Financing

Businesses generally choose between going into debt or giving up equity to fund their businesses. Let’s break down the difference between debt and equity financing to help you determine which option best aligns with your business goals.

With debt financing, you retain ownership over your business and pay on a fixed schedule. You’re on the hook for interest and may have to provide collateral, such as your home or car, but you don’t have to share the profits with investors or other parties.

Equity financing, on the other hand, involves raising money by selling shares of your company to investors. You don’t have to repay their investment or pay interest, but you give up a portion of your company. In practice, this can hurt your ability to make business decisions, potentially diluting your mission. Equity financing is also more time-consuming and has a lot of legal consequences, so many small businesses start with debt financing.

In-Summary: What Is Debt Financing?

Businesses turn to debt financing to borrow money that must be repaid over time with interest. Unlike equity financing, which involves giving up ownership shares, debt financing allows businesses to retain full control while securing funds for growth, operations, or other financial needs. This approach comes with both advantages, such as tax benefits and predictable payments, and disadvantages, including repayment obligations and interest costs.

However, alternatives like altLINE invoice factoring offer businesses quick funding without interest or long-term payment schedules. If you have questions about factoring or think your business could be a good fit, we’d be happy to guide you in your decision-making process. Feel free to call one of our representatives at +1 (205) 607-0811 or fill out our free factoring quote form.