What is Debt Financing?
Debt financing is when a company raises funds by borrowing money. In this approach, the borrower agrees to repay the amount with interest over a predetermined period. This method of financing often involves loans, bonds, or lines of credit from financial institutions like banks, cash flow-based financing companies like GetVantage or issuing corporate bonds to investors. The major characteristics of debt financing are –
- Obligation to Repay: Borrowers are legally required to repay both the principal and interest.
- Fixed Payment Schedule: Repayments are typically structured in regular intervals (monthly, quarterly, etc.).
- Interest: The lender charges interest on the borrowed amount, which is the cost of borrowing.
- No Ownership Dilution: Unlike equity financing, where investors gain ownership or shares, debt financing doesn’t involve giving up equity.
Types of Debt Financing
Business Loans
Business loans offer companies short or long-term financing for operations, equipment, or expansion. Depending on creditworthiness, they can be secured by assets or unsecured.
Bank Loans
Bank loans involve borrowing a lump sum from a bank with fixed repayment terms. These loans are used for major expenses like equipment purchases or business expansion, and repayment includes both the principal and interest.
Line of Credit
A line of credit provides flexible borrowing up to a pre-set limit, with interest charged only on the amount used. It’s ideal for managing cash flow or covering unexpected costs.
Bonds
Bonds are long-term debt instruments where a company or government raises capital from investors. Bondholders receive regular interest payments, and the principal is repaid at maturity.
Debentures
Debentures are unsecured loans that rely on the issuer’s reputation rather than collateral. They are commonly used by well-established companies for long-term funding.
Commercial Paper
Commercial paper is short-term, unsecured debt issued by large companies to meet immediate financial needs, such as payroll or accounts payable. It typically matures within 270 days.
Difference between equity and debt funding
Equity and debt financing are two primary ways businesses raise capital. Equity financing involves selling ownership shares in the company to investors. These investors become part-owners, sharing in profits and losses. It provides flexibility, no repayment obligation, and can attract strategic partners. However, it dilutes ownership, requires sharing control, and the valuation process can be complex.
Debt financing, on the other hand, involves borrowing money from lenders. The business repays the principal amount with interest over time. It maintains ownership control, offers tax benefits, and can be a faster process. But, it carries the burden of regular interest payments, increases financial risk, and can limit future borrowing capacity.
The choice between the two depends on factors like risk tolerance, control preference, financial health, and long-term goals. Often, businesses combine both to optimize their capital structure.
Debt funding for startups is generally more suitable for companies with steady cash flow and financial stability. These companies can manage regular debt payments and benefit from the tax-deductibility of interest payments.
On the other hand, equity financing is more appropriate for startups or companies with uncertain cash flows. Since equity doesn’t involve regular repayments, it’s a less risky option for businesses still in their early stages or those seeking to proliferate.
Why is funding required for startups and MSMEs?
Product Development and Manufacturing
Developing a new product or service requires significant research, prototyping, and testing investment. Scaling production and ensuring quality control demands machinery, materials, and labor capital.
Marketing and Sales
Substantial marketing budgets are needed to create brand awareness and establish a strong market presence. Attracting and retaining customers requires investment in advertising, promotions, and sales efforts.
Hiring and Talent Acquisition
Hiring skilled professionals, especially in specialized fields, involves significant costs. Paying competitive salaries and benefits is essential to attract and retain top talent.
Operational Costs
Renting office space, setting up infrastructure, and maintaining operations incur ongoing expenses. Legal fees, accounting, and other administrative tasks require financial resources.
Cash Flow Management
Startups often have high upfront costs and may not generate immediate revenue. Expanding operations and capturing market share can strain cash flow.
Risk Mitigation
Startups face unforeseen hurdles, such as economic downturns, supply chain disruptions, or competitive threats. Funding provides a safety net to weather these challenges.
Considerations on debt financing for founders
- Ensure steady and reliable income to cover debt payments.
- Assess current credit history and ratings. Limited credit can restrict access to loans or lead to higher interest rates.
- Retain full ownership compared to equity financing.
- Evaluate the total cost of borrowing, including interest and fees.
- Align debt use with overall business goals and growth plans.
Conclusion
GetVantage is a Capital Gateway and Embedded Finance Fintech Platform providing digital businesses and MSMEs access to fast, fair, flexible, and founder-friendly Cash Flow-Based Financing between ₹ 2 lac – ₹ 20 cr. Built by founders for founders, the platform provides equity-free funding for marketing, inventory, logistics, and other recurring CapEx to businesses. In 4 years, we have built a strong and exciting portfolio of over 1500+ new-age businesses across 25+ sectors.
