While larger, long-established businesses can rely on traditional bank loans to fund growth initiatives, small and middle-market businesses must rely on other types of debt financing.
In large part, the reason comes down to the broadening influence of federal regulation.
Ever since the 2008-09 financial crisis, investment banks and traditional lending sources have been less and less willing to lend to small and medium-sized businesses. Instead, they now overwhelmingly favor established businesses with a consistent history of cash flow, sufficient collateral, and a favorable debt-to-income ratio.
Companies with a short history of operation or poor credit history may be entirely unable to secure a bank loan. To make matters more complicated, frequent declines for a loan could decrease your chances of landing another one from the same institution.
Yet that doesn’t mean you’re out of luck. Over the past decade, small companies have sought out financing from alternative sources of debt financing. Not only is it now easier to secure capital outside of banks, but many companies actually prefer these other types of debt financing due to their relative flexibility.
Common sources of debt financing include business development companies (BDCs), private equity firms, individual investors, and asset managers.
Advantages of debt financing
- Maintain control of your business. Debt financing allows you to maintain complete control of your business, unlike equity financing. Whereas an investor receives an equity position in your business, a lender has no part in running your company.
- Tax-deductible interest payments. In most cases, the interest payments on your debt financing will be tax deductible. This interest tax deduction is generally available as long as you’re borrowing money from an actual lender (and not friends or family) and using it for business purposes. Other loan costs, such as origination fees, can also be tax-deductible.
- Easier to plan for the future. With debt financing, you can access capital relatively quickly and invest it in your business’s growth. And because you know how much you’ll need to repay every month, it’s easier to budget and plan for your company’s future.
- Build business credit. Making timely payments on your debt financing can help establish and build your business credit. Developing a strong business credit history can help you qualify for loans with the most competitive interest rates and repayment terms in the future.
Disadvantages of debt financing
- Can risk assets or credit history. Taking on debt can be risky for your business and personal finances. To get financing, you may have to put up your business assets as collateral or sign a personal guarantee. If you default on the loan, the lender can seize your business assets — or in the case of a personal guarantee, your personal assets — to recoup their losses. Late or missed payments could negatively impact your credit history, making it more difficult to qualify for financing in the future.
- Can be a financial strain on the business. Debt can make it difficult to manage your business finances. You’ll need to make consistent payments on your loan, regardless of your revenue, which can be particularly taxing on seasonal businesses or those with inconsistent cash flow. Some businesses may also find it more challenging to try and grow operations while managing and repaying debt.
- Can be difficult to qualify. Although debt financing is often easier to access than equity financing, it can be difficult to get options, like bank loans, that offer the most competitive terms and business loan rates. To get a bank loan, for example, you’ll typically need excellent credit, several years in business and strong finances. You may also have to put up collateral. Newer businesses and those with fair or bad credit may have a harder time accessing affordable debt financing.
How to choose debt financing for your business
If you’re thinking about financing your business with debt, consider the following factors to find the right option for your needs:
- Why you need funding.
- How much capital you need.
- Your business’s qualifications (e.g., personal credit score, time in business, annual revenue).
- How fast you need access to funding.
- How much debt you can afford.