There are really two choices when it comes to financing your business – debt and equity. Debt is typically a loan with a specified interest rate and an obligation to pay back the principal and all accrued interest. Debt is riskier than equity. It has defined repayment periods and default provisions that typically allow the lender to take control of your business and all of its assets if the debt goes into default.
The advantage of debt is that it typically lets you retain the ownership of your company (so long as the debt is not in default) and is usually less costly than equity.
Equity in its simplest form is an investment made by a third party for the right to share in the ownership and profits of the company. Because there is a greater risk of non-payment to an equity holder than a debt holder, equity usually comes at a greater cost than debt. But equity is less risky to the founders, because there is no fixed repayment date. The equity holders only get paid when the company generates a profit and the company agrees to distribute its profits to the equity holders.
Debt financing is typically issued by a bank or a similar financial institution. Banks traditionally issue loans that are secured and must be repaid within seven years, unless extended for additional years. Banks typically secure their loans by taking a first priority security interest in the company’s assets such as real estate, equipment, inventory, and accounts receivable.
This gives the bank a preference to those assets in the event of a liquidation or bankruptcy. Banks will also often require the owners of a small, privately held company to personally guarantee the loan, especially if the company has a limited history of profitability.
The amount that a bank will loan is typically a set percentage of the value of the collateral securing the loan, including the value the bank attributes to any personal guarantee. Further, the interest rate is typically pegged to something at or above the current LIBOR rate (London Interbank Offered Rate) or Prime rate, depending on the perceived risk of nonpayment on the loan.
Banks traditionally offer two different types of business loans, term loans and a line of credit or a working capital loan. A term loan typically requires repayment of the entire loan, both principal and interest, within seven years. A line of credit usually requires repayment within one or two years, but is commonly extended for an additional number of years if the company remains in compliance with the terms of the loan, including the financial ratios or covenants required by the bank.
A line of credit is commonly used to help a company manage cash flow issues associated with: (i) time lags between getting paid on its invoices (accounts receivable) and keeping current on its outstanding bills (accounts payable) and (ii) seasonality of the business. Term loans are typically used to finance plant and equipment expenditures or acquisitions.
Many financial institutions offer loans that are partially guaranteed by the Small Business Administration (SBA). To qualify for these types of loans, you must prove that you were not able to obtain financing elsewhere on reasonable terms and demonstrate that you are able to meet the SBA criteria for the issuance of the loan, most important of which is your ability to repay the loan. SBA guaranteed loans are typically used when a company does not have sufficient collateral to obtain a bank loan.
These types of loans take longer to close because of the additional paperwork associated with SBA loans and the requirement that you obtain approval from both the financial institution and the SBA. Additionally, SBA regulations require personal guarantees from the owners.
The SBA guaranteed loans include both term loans and lines of credit or working capital loans.
Another commonly used debt type instrument is a lease for expensive equipment such as heavy machinery, trucks, computers, medical equipment, or the like.
Under the terms of the lease, the financial institution keeps title to the equipment while you pay off the lease. Most lease arrangements provide an option to purchase the equipment for a certain price either during the term of the lease or at the end of the lease.
While you may pay more for the equipment over time, a lease helps give you time to pay for the equipment and can help you preserve cash during the critical growth phase of your company.
Clay Gill is a business and employment lawyer in the Boise office of Moffatt, Thomas, Barrett, Rock & Fields, Chtd. He is the primary author of the on-line manual, “Things to Consider When Starting up a Company in Idaho, A Lawyer’s Perspective,” posted at www.startup-Idaho.com. Mr. Gill can be reached at firstname.lastname@example.org or (208) 345-2000.