Raising capital is one of the uphill tasks entrepreneurs must overcome to build their business. It is a complete roller coaster as things can change at breakneck speed. That’s why understanding debt capital is imperative. So, what is debt capital?
Capital refers to assets or cash required by a business to provide goods and services to its customers. Whether it’s a salon, medical facility, manufacturing, restaurant, retail, etc., all businesses require capital to operate.
Although capital requirements vary depending on several factors, all businesses need it to remain afloat. Business owners who lack often turn to debt capital or equity capital. Both types of capital can provide the needed funding. However, there are stark differences between them.
Continue reading to learn more about debt capital, types of debt capital and so much more.
What is Debt Capital?
Debt capital refers to funds or assets generated by borrowing from a lender. Usually, a business owner takes on debt to get capital. For example, traditional bank loans are debt capital.
Most entrepreneurs prefer debt capital over equity capital because they don’t have to forfeit business ownership. The drawback, however, is that debt capital can be more challenging to secure. If your business is relatively new, banks may be hesitant to finance for lack of a proven track record.
In equity capital, business owners don’t take on debt. Instead, investors purchase partial ownership in the business (equity) and the owner is not required to repay.
It is generally easy to acquire equity capital. Startup businesses struggling to obtain traditional debt capital often look to equity capital. So long as they can pitch an idea to an investor successfully, the investor can offer capital in exchange for equity. Unfortunately, you’ll have to forfeit part of your business, something most entrepreneurs don’t like. Why?
Benefits of Debt Capital
1. Maintain ownership
Once you acquire debt capital, you become obligated to make agreed payments on time. You continue owning your business without outside interference.
2. Tax deductions
This is a major attraction to debt capital. Usually, the principal and interest payments fall under business expenses and deducted from your business’s income at tax season.
3. Low interest rate
Examine the effect of tax deductions on the bank interest rate. If the lending institution charges you 10% of your loan and the tax is at 30%, then there’s a benefit taking a loan you can deduct.
Demerits of Debt Capital
You must make payments even if your business fails. And if you’re forced into bankruptcy, lenders usually have repayment claims before equity investors.
2. High interest rates
You may pay high interest since rates vary with macroeconomic conditions, your business credit score, personal credit rating and history with the lender.
3. Cash and collateral
Ensure your business will generate enough cashflow to repay the loan. Lenders may ask you to put up collateral to protect them incase your default on payments.
Types of Debt Capital
Business Credit Cards
Business credit cards offer business owners easy access to revolving but limited line of credit. Like ordinary credit cards, business credit cards also carry interest charges if balances are not repaid in full ever billing cycle.
Pros of Business Credit Cards
- Easy qualification: It is easier for entrepreneurs who don’t have a well-established credit history to qualify as compared to traditional loans.
- Convenience: Business owners can access funds quickly. Business credit cards are convenient.
- Bookkeeping assistance: Most cards offer business card holders online bookkeeping tools to track and manage their accounts.
- Build credit score: When used responsibly, business credit cards can build good credit score. Pay bills on time, don’t exceed credit limit and pay above minimum due
Cons of Business Credit Cards
- Expensive: Convenience of business credit cards come at a cost. They usually charge high interest rates as compared to SBA loans and lines of credit offered by financial institutions.
- Personal legal liability: Most business credit cards need a personal liability agreement to repay loans. Defaulting or late payment could adversely affect your credit rating.
- High fees: Look out for high late payment fees, annual fees, cash advance fees and others.
Microloans are small and easy to obtain loans given to small businesses by some lenders. They are usually offered to businesses that require capital r to begin or run their operations.
Pros of Microloans
- Low interest rates
- Ideal for small and medium sized businesses (SMBs) with limited access to capital
- SBA can be an intermediary
Cons of Microloans
- Require good personal finance history to qualify
- Can be difficult to acquire if not in the targeted type of business.
- Short terms
- May need personal guarantee or collateral
Small Business Administration (SBA) Loans
SBA microloans are the most popular type of debt capital. SBA’s mission is to promote the growth of small businesses. As such, SBA offers loan programs for enterprises that are struggling to secure capital.
SBA microloans can give up to $50,000 in funding. To qualify, you need to justify why you need the capital and how much. Also, you have to demonstrate that you’re capable of repaying.
Pros of SBA Microloans
- Loans processed and distributed quickly (approximately 1 month)
- SBA provides financing to business that traditional lenders don’t give.
- SBA funds can settle various business needs and costs.
- SBA loan forgiveness gives you the chance to propose reasonable amount you can manage to repay.
Cons of SBA Microloans
- May take longer for an SBA approved loan to get approved and disbursed making it unsuitable for businesses facing immediate cash crunch.
- You must work with a traditional financial institution and the government.
- Every lender sets their own eligibility requirements.
- Lenders can charge fees which vary
- Can be difficult to qualify for
- Come with spending restrictions. For instance, you can’t clear an existing debt or purchase real estate unless you apply for a commercial bridge loan.
Unsecured Business Loans
An unsecured business loan appears more advantageous than a secured loan. You don’t need to provide collateral, like property, business equipment or inventory to get financing. However, you may need to sign a personal guarantee. Also, they’re likely to attract high interest rates than secured business loans.
Equipment financing is relatively easy to qualify for. The amount you borrow depends on the equipment you plan to acquire. Because the equipment you’re buying can secure the loan, you may not need to provide extra collateral.
For instance, healthcare practitioners can apply for medical equipment finance to kickstart their private practice. Without equipment finance, such venture would be nearly impossible since equipment are expensive.
Pros of Equipment Financing
- Less documentation needed than traditional loans.
- You don’t have to look extra cash to pay upfront cost of purchase.
- Tax incentives: Equipment financing is usually tax deductible for small business owners.
Cons of Equipment Financing
- Financed equipment may become outdated.
- May require high down payment.
- Needs good credit for good terms.
When looking for any type of debt capital, remember certain providers are familiar and like to work with specific businesses. Take time to look around and make sure your preferred choice is well acquainted with your industry.