You have finally finished the beta test of your disruptive new app, you have an impressive business model and a “one-in-a-million type product” that you know will fly. Ready to launch, you find yourself at a roadblock – you need money!
In our previous article we touched on the essence of equity financing and the importance of keeping investors happy. Today we have a look at debt financing, the pros and cons and why so many start-ups choose this viable option.
Let’s take a closer look.
What is debt financing?
It’s the type of financing that most of us are already familiar with. When you take out a home loan, obtain a loan to buy a car, or purchase something using a credit card, you are using a form of debt financing.
Basically, debt financing means an individual or organisation is lending you money that you must pay back with interest at a future date.
Pros and cons
Pro: Probably the biggest pro of debt financing is that you retain full control and ownership of the business. You don’t need to give away shares. Once the loan is paid off, you are free and clear of any obligation and free to run the business on your own terms.
- Liquidity restrictions
Con: When you take on debt financing, you will immediately owe regular payments, the same as a monthly mortgage payment or a vehicle instalment. The repayment terms may differ depending on the type of loan. This will take away from the available capital you have to run your company, which is crucial for early stage businesses.
Pro: Debt financing is available in a wide variety of forms, including short and long-term loans, inventory and equipment loans, guaranteed loans and even personal loans.
- Personal risk
Con: If you fail to pay back the loan, or make late payments, it can hurt your business and/or personal credit rating, which will make it more difficult to get financing in the future. If you have put up security for the loan, you may lose your security.
How does it compare to equity financing?
Another way to make sure that debt financing is the route you should follow, is to compare it with equity financing and see which one would suit your current position best.
Here are three things to consider:
If you don’t have a problem sharing ownership of your business, reporting to investors and managing investor relationships at an early stage, then equity financing could be the better way to go. Investors can offer you a lot of business experience and advice.
- Financial projections
If there are still doubts around the size of the market or how the consumer might take up your product, the risk element may be too large to opt for debt financing. Bringing on an investor who is willing to take that risk in exchange for shares in the company, will therefore be the wiser move. However, if financial projections are sound and you are confident that you will be turning a profit sooner rather than later, debt financing is a very viable option.
Related: New Ways SMEs Can Find Funding
- Advice or guidance vs need for operating capital only
It is as simple as deciding whether you just need money or whether you want the possible guidance, connections and industry experience the investor puts on the table.
In closing, no matter how you choose to fund your start-up, make sure that you have taken your product for a test drive. You don’t want to risk investing your own money and even worse, someone else’s money, on something that has no chance of gaining any traction with customers. Many successful entrepreneurs decide to adopt a lean approach by starting out with a minimum viable product (MVP), bootstrapping and then committing to basic market testing prior to seeking out any investment.
Once you’ve raised your funding, be it by debt or equity financing, make sure to take a moment, reflect, raise the champagne glasses and then… go out, work hard and give it all you’ve got!