DEBT FUNDING EXPLAINED

Which type of funding is best for my business, debt or equity?  Should it come from banks, angel investors, or venture capitalists?
Debt Financing

Commercial loans are attractive because they don't require entrepreneurs to turn over equity or company control.  But servicing debt can drain a young company with limited cash flow. 

Banks will expect you to present your previous three years of financial statements, along with a complete business plan.  Many of the Resource Partner's in the Urban Entrepreneur Partnership network assist small companies and individuals in building business plans.

U.S. Small Business Administration loan programs

The Small Business Administration has several loan programs which make it easier for banks to provide loans to small business, but the federal agency loans no money directly.  The SBA instead guarantees 75 percent of individual loans made by private lenders, up to $750,000, but a business must first show that it cannot obtain conventional financing at reasonable terms.  Because of this guarantee, fees associated with SBA loans make the loans more expensive than a non-SBA backedcommercial loan.  BA loans are therefore ideal for businesses that might be considered too high of a risk for traditional business loans.  Business owners must personally guarantee SBA loans and must also show cash flows sufficient to repay the loan.  Most commercial banks offer information about SBA loans. For more information on SBA loan guarantees, click here to visit their website.

What Banks Like

In general, banks prefer to make loans of over $10,000 or so, as the administrative cost on a small loan is too high to make it profitable from the banks perspective. Businesses seeking loans of smaller amounts often obtain personal loans (see “other types of debt financing” below).

What banks like to see in a loan application:

• Good credit

• A solid business plan

• Ability to repay the loan

• Collateral

A line of credit

An arrangement in which a bank extends a specified amount of credit to a specified borrower for a specified time period (also called credit line). A line of credit is best suited to help cover expenses that tend to fluctuate throughout the course of a year.  This type of loan is not “termed” or does not have a fixed monthly payment or term of repayment. 

How much can you expect a bank to loan against different types of collateral

Percentages used by one area bank:

 • 50% of receivables 

 • 50% of inventory

 • 80% of new equipment 

 • 0% of works in progress—a coffee cup that is only 50% complete doesn’t have much value

 • 50% of used equipment

 • 80% of commercial real estate

Other banks will vary, but this should provide a basic guideline.

Banks like to match the duration of the loan to the duration of the collateral.  For example, they would not want to finance a new building that has a life span of 40 years with receivables that only have a duration period of 3 months.

Other types of Debt Financing

Home Equity Loans

Home equity loans are a cost-effective alternative to other types of loans because they offer some of the best interest rates available.  But you may not want to risk your family home to launch your business venture.  Before going this route, you should carefully consider the risks involved.

Credit Cards

Cash advances from credit cards are an easy and quick way to gain access to cash.  But as a long-term financing method, they can be expensive -- credit card interest rates typically run much more than the 1 to 3 percent "over prime" you would likely pay on a bank loan.  If you use credit cards, shop for the best interest rate. Introductory "teaser" rates often give you a bargain for up to six months.  If you have the time and energy, you can roll over your debt to a new card every six months, taking advantage of a new teaser rate.

Equipment Leasing

Equipment lease financing is an option for many cash-starved businesses. Equipment leases give you access to many types of equipment -- computers, copiers, fax machines, cars and trucks -- without tying up your cash or credit lines. Although it doesn't bring in cash, leasing reduces the amount of cash you otherwise have to raise. Leasing generally proves more costly than buying in the long run, but if cash flow is an issue for your company, it's definitely something to consider.