To secure much-needed capital to get over temporary budgetary hurdles or fund inventory purchases and business expansion, companies commonly turn to debt financing. As long as they wisely use the borrowed money, businesses can dramatically increase revenue, pay off debts and become much more successful in the future. However, debt financing does come with risks.
Types of Debt Capital Financing
The most basic and prevalent type of debt capital financing is a bank loan. Banks offer competitive loan rates. However, since they offer such competitive rates, banks expect you to show that your company is not a risk. You need to verify your financial history and prove that you will be able to make your loan payments.
Another type of debt capital financing is a business line of credit. These often come from the same institutions as business loans. The business line of credit differs from a loan in that, like a credit card, the lender only charges interest on what you use.
A third common type of debt capital financing is an equipment lease. For expensive equipment, manufacturers and distributors often offer leasing solutions in much the same way that automakers and banks offer loan and leasing plans for vehicles. If you are choosing between a bank loan to buy equipment and an equipment lease from the distributor, the equipment lease often has less stringent requirements.
Risks of Losing Collateral
In getting your business loan or line of credit, you may have to pledge some of the company's valuable holdings -- such as real estate -- as collateral. Whatever you pledge as collateral becomes subject to seizure by the lender if you default on your debt. If this happens, it could cripple the company's operations.
Risks to Your Credit Rating
If you incur a debt to fund a business expansion and then default on that debt -- or just make a few late payments -- it could dramatically lower your company's credit rating. If that happens, it becomes much more difficult to raise money in the future, since lenders look at your credit rating to determine creditworthiness. Since access to credit is important to business growth, failing to make payments can hobble your business's ability to grow in the future.
Debt Financing vs. Equity Financing
Debt financing has different risks than equity financing does. While creditors in a debt financing arrangement do not own the company or any of its assets unless the company defaults, investors in an equity financing arrangement are buying a piece of the company. When "angel investors," or venture capitalist firms, give you money to grow your business, they expect to become partial owners. This means that, unlike lenders, they expect to be included in future business decisions. In an equity financing situation, you run the risk of giving power to others who may not know what your business needs to do to succeed.
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