Prep

Funding 101: Prep

 

Debt

The most common form of outside capital for new businesses is Debt.

Although Angel Investors and Venture Capitalists get all the big headlines for funding exciting companies, it's the Debt providers - banks, lenders, and specialty finance companies - that truly power most of the investment dollars that go into companies.

 

Greed is Good. And so is Debt.

Entrepreneurs turn to Debt for two reasons: either investors won't give them capital for equity, or the entrepreneur just doesn't want to give up equity.  Most entrepreneurs are greedy with their equity, and they should be.  Once you give it up, it's nearly impossible to get back.

Most entrepreneurs are greedy with their equity, and they should be.  Once you give it up, it's nearly impossible to get back.

Therefore, a great way to maintain the ownership and control of your company, especially in the formative stages when you're most susceptible to dilution from outside investors, is to use Debt.

When to Use Debt

There are a handful of scenarios where Debt is by far the most useful option for financing your company.

When Equity isn't available.  Whether or not you want an Equity investor, there are often times when one isn't available.  Maybe your business is too early for an investor, or maybe you're building a business where most investors don't tend to invest in. 

When you need Capital Quickly.  Raising investor capital takes a lot of time.  Even if things go well, you will likely be out shopping for capital and closing the paperwork for at least 3 months before you have capital ready.  Most debt options, assuming you have your information together, are accessible in less than 45 days.

For Less than $50,000.  For amounts less than $50,000 there are quite a few debt options available that include SBA loans, MicroEnterprise Loans, and even high value business credit cards.  These tend to be good options for finding some startup operating cash.

For Real Estate and Equipment. If you're looking for property or equipment you're in luck - banks tend to understand that stuff really well.  Anything that is a hard asset that the bank can use as collateral usually makes a good candidate for using debt to finance the item.

Lending and Collateral 101

The name of the game in debt financing is collateral.  The more you have, the better your chances of getting larger amounts of financing.

Despite what you may think, banks don't make that much profit on a single loan.  Especially if a few go bad.  So the only way they can maintain their margins is to only say "yes" to the deals where they can be sure they absolutely won't lose out.

The name of the game in debt financing is collateral.  The more you have, the better your chances of getting larger amounts of financing.

That's where collateral comes in.  An entrepreneur's promise to pay back a loan is nice, but a guarantee is what the bank really cares about.  The bank needs to know that if things go sour, as they often do in business, they are protected.

Two Types of Collateral – You and Stuff

Imagine you're the lender and the loan you just gave to some aspiring entrepreneur just defaulted.  You loaned that guy $50,000 a year ago but have only collected $5,000 in payments back. You're at least $45,000 in the hole and no amount of interest from good loans is going to make that easy to digest!

What are your options?  The business is out of business, so there is no way to recoup your losses there.  Your only options then are to try to sell the assets of the company or to try to get the entrepreneur to pay you back out of his own pocket.  That's it.

For this reason the bank cares about collateral above all else.  This actually makes it pretty easy to understand their motivations.  Just think about how they will recoup their losses if you default on the loan.  If you can think like a banker for just a moment, the requirements will seem pretty obvious.

What you can do with no Collateral

If you don't have any collateral and you don't plan on signing for the loan personally, your options are mostly limited to smaller loans (usually less than $50,000) that are supported by the U.S. Small Business Association.

In this case our wildly indebted yet somehow solvent government is playing co-signer on your loan. 

The loan amounts will be smaller because Uncle Sam needs to hand out lots of checks to lots of people.  But the benefit is he may be the only Uncle that is willing to bet on your new idea right now. 

 

Credit is Comparable

In some cases you can achieve the same goals with credit since the upper end limits for business users tend to be about the same. 

American Express, for example, offers both a 30-day charge card with a floating limit and a more traditional credit card that offers flexible monthly payment options. 

Of course this is going to tie back to your personal credit at some level, so in this case you're choosing between a quick credit decision from a credit card company compared to a lengthy loan application process through a bank.

The Four Categories of Debt

There are many different loans types but it's easy to group them in terms of what situation you're likely facing.  Beyond this there are lots of specialty loans for particular situations like veterans who are starting businesses or folks building a company in an area of town deemed to be

Less than $50k with no collateral. Without collateral, your financing options are limited to SBA-backed loans, MicroEnterprise Loans, Business Credit Cards, and Business Credit Lines.

 

Your Business has Revenue.  If you have existing revenue you can use that as collateral to borrow against.  This will enable you to leverage options with Merchant Cash Advance and Receivables Factoring that can provide cash quickly.

You Have Collateral. If you have collateral, you can relatively easily obtain a line of credit or traditional bank loan. If the loan is only needed to fund a cash shortage, you can often pledge inventory for a short term loan or line of credit. For longer term loans, company or personal assets will need to be used as collateral.

 

You're Buying Property or Equipment.  Whenever the purpose of your loan is to buy an item that can act as collateral (in the event the bank needs something to repossess) you have lots of options.  Equipment Financing, Commercial Real Estate Loans, and Acquisition Loans are all great candidates for financing.

Summary

Debt is a great tool for a small business if you know where and how to use it.  The benefit of not giving up equity and creating a more obvious path to funding is very appealing to entrepreneurs.

When considering your funding options, explore all of your Debt options in detail to see what's available.  Our position on Debt is always this - it's better to have financing and not need it than to need financing and not have it!