Debt financing involves getting a loan or selling corporate bonds. Because it is virtually impossible for a new venture to sell corporate bonds, we’ll focus on obtaining loans.
There are two common types of loans. The first is a single-purpose loan, in which a specific amount of money is borrowed that must be repaid in a fixed amount of time with interest. The second is a line of credit, in which a bor- rowing “cap” is established and borrowers can use the credit at their discretion. Lines of credit require periodic interest payments.
There are two major advantages to obtaining a loan as opposed to equity funding. The first is that none of the ownership of the firm is surrendered—a major advantage for most entrepreneurs. The second is that interest payments on a loan are tax deductible, in contrast to dividend payments made to inves- tors, which are not.
There are two major disadvantages of getting a loan. The first is that it must be repaid, which may be difficult in a start-up venture in which the entrepre- neur is focused on getting the company off the ground. Cash is typically “tight” during a new venture’s first few months and sometimes for a year or more. The second is that lenders often impose strict conditions on loans and insist on am- ple collateral to fully protect their investment. Even if a start-up is incorporated, a lender may require that an entrepreneur’s personal assets be collateralized as a condition of the loan. In addition, a lender may place a stipulation on a loan, such that the borrower must “maintain a cash balance of $25,000 or more” in its checking account or the loan will become due and payable.
The three common sources or categories of debt financing available to en- trepreneurs are described next.
1. Commercial Banks
Historically, commercial banks have not been viewed as practical sources of financing for start-up firms.36 This sentiment is not a knock against banks; it is just that banks are risk averse, and financing start-ups is risky business. Instead of looking for businesses that are “home runs,” which is what venture capitalists seek to do, banks look for customers who will reliably repay their loans. As shown in Table 10.2, banks are interested in firms that have a strong cash flow, low leverage, audited financials, good management, and a healthy balance sheet. Although many new ventures have good management, few have the other characteristics, at least initially. But banks are an important source of credit for small businesses later in their life cycles.
There are two reasons that banks have historically been reluctant to lend money to start-ups. First, as mentioned previously, banks are risk averse. In addition, banks frequently have internal controls and regulatory restrictions prohibiting them from making high-risk loans. So when an entrepreneur ap- proaches a banker with a request for a $250,000 loan and the only collateral he or she has to offer is the recognition of a problem that needs to be solved, a plan to solve it, and perhaps some intellectual property, there is usually no practical way for the bank to help. Banks typically have standards that guide their lending, such as minimum debt-to-equity ratios that work against start- up entrepreneurs.
The second reason banks have historically been reluctant to lend money to start-ups is that lending to small firms is not as profitable as lending to large firms, which have been the staple clients of commercial banks. If an entrepre- neur approaches a banker with a request for a $25,000 loan, it may simply not be worth the banker’s time to complete the due diligence necessary to deter- mine the entrepreneur’s risk profile. Considerable time is required to digest a business plan and investigate the merits of a new firm. Research shows that a firm’s size is an important factor in determining its access to debt capital.37
The $25,000 loan may be seen as both high risk and marginally profitable (based on the amount of time it would take to do the due diligence involved), making it doubly uninviting for a commercial bank.38
Despite these historical precedents, some banks are starting to engage start-up entrepreneurs—although the jury is still out regarding how signifi- cant these lenders will become. When it comes to start-ups, some banks are rethinking their lending standards and are beginning to focus on cash flow and the strength of the management team rather than on collateral and the strength of the balance sheet. Entrepreneurs should follow developments in this area closely.
2. sBA guaranteed loans
Approximately 50 percent of the 9,000 banks in the United States participate in the SBA Guaranteed Loan Program. The most notable SBA program available to small businesses is the 7(A) Loan Guaranty Program. This pro- gram accounts for 90 percent of the SBA’s loan activity. The program operates through private-sector lenders who provide loans that are guaranteed by the SBA. The loans are for small businesses that are unable to secure financing on reasonable terms through normal lending channels. The SBA does not cur- rently have funding for direct loans, other than a program to fund direct loans for businesses in geographic areas that are hit by natural disasters.
Almost all small businesses are eligible to apply for an SBA guaranteed loan. The SBA can guarantee as much as 75 percent (debt to equity) on loans up to $5 million. For loans of $150,000 or under, the guaranteed amount is 85 percent. Guaranteed loan funds can be used for almost any legitimate busi- ness purpose. The maximum lengths of the loans are seven years for working capital, 10 years for equipment (or useful life of equipment), and 25 years for real estate purchase. To obtain an SBA guaranteed loan, an application must meet the requirements of both the SBA and the lender. Typically, individuals must pledge all of their assets to secure the loan. Interest rates are negotiated between the borrower and the lender but are subject to SBA maximums.39
Although SBA guaranteed loans are utilized more heavily by existing small businesses than start-ups, they should not be dismissed as a possible source of funding. There is a general misconception that the SBA is a “lender of last resort” and only distressed businesses qualify for SBA guaranteed loans. Just the opposite is true. Only viable businesses are eligible under the SBA 7(A) Loan Guaranty Program.40
3. Other sources of Debt financing
There are a variety of other avenues business owners can pursue to borrow money or obtain cash. Vendor credit (also known as trade credit) is when a vendor extends credit to a business in order to allow the business to buy its products and/or services up front but defer payment until later. The practice is especially common in retail, but it can be seen in other businesses as well. An example of vendor credit is when a retailer orders product from a vendor that ships it on net 30 terms. This means that the retailer has 30 days to submit payment for the product. The idea is that the retailer doesn’t have money to pay for the product until it sells it, so the vendor agrees to wait on payment to give the retailer enough time to sell the product and collect the money needed to pay the bill. Some retailers will negotiate up to net 90 terms, meaning that they have 90 days to make payment. Although not really debt financing, fac- toring is another way that businesses generate cash. Factoring is a financial transaction whereby a business sells its account receivable to a third party, called a factor, at a discount in exchange for cash.41
There are also alternative lenders who loan money to small businesses and entrepreneurs. These are primarily online firms that offer loans at an esca- lated interest rate. A common type of alternative lending is the merchant cash advance. In a merchant cash advance, the lender provides a business a lump sum of money in exchange for a share of future sales (typically a set percentage of the business’s daily credit card sales) that covers the payment amount plus fees. The deals are normally designed for borrowers looking for short-term loans of less than $100,000. The average time for repayment is eight to nine months.42
Another type of alternative lending is peer-to-peer loans. Peer-to-peer lend- ing is a financial transaction that occurs directly between individuals or “peers.” The loans are facilitated by online firms such as Funding Circle, Lending Club, and Dealstruck. The online firms connect businesses with individuals or insti- tutional investors who make the loans. In some cases, such as with Dealstruck, the site itself has money to lend. Borrowers generally must make fixed monthly payments. The thing to watch out for when using alternative lenders is the an- nual percentage rate (APR), which can run as high as 12 percent to 25 percent.43
Source: Barringer Bruce R, Ireland R Duane (2015), Entrepreneurship: successfully launching new ventures, Pearson; 5th edition.