Debt. It’s not the prettiest word in your business glossary, but it is one of the most useful. Understanding the truth about small business loans and other forms of debt financing will reveal opportunities for growth, and it will help you manage your business with confidence.
Here are three myths that small business owners believe about debt—and the realities behind them.
Myth #1: Debt financing = small business loan from a big bank
When you hear “debt,” do you think of a variety of options?
Myth #1 has two errors. It assumes that debt only comes in one form, and that debt financing only comes from one source. In reality, there are half a dozen forms of debt financing for different purposes and a variety of lenders for different business types.
Debt financing comes in many forms.
- Term loans: Like mortgages, term loans for business involve a specific amount of capital paid back, with interest, on a set schedule. A term loan is the most common form of a small business loan.
- Lines of credit: These are large amounts of capital available as short-term loans.
- Small business credit cards: This very accessible option is great for covering short-term fluctuations but should be managed with special care.
- Merchant cash advances: An MCA is a short-term loan based on your monthly sales and often paid back based on a percentage of future sales.
- Invoice discounting: In invoice discounting, your business borrows money from an invoice discounting company against money you are owed.
Debt financing comes from many sources. While big banks only approve about 23% of funding requests, the approval rates at alternative lenders, small banks, institutional lenders and credit unions are all 2-3 times that figure.
Myth #2: Debt kills young businesses
If debt killed young businesses, the majority of young businesses would die. In fact, young companies rely heavily on debt. In fact, three quarters of their funding comes from small business loans, credit cards and lines of credit.
Established and expanding businesses don’t shy away from debt either: Bank credit is one of their top two sources of financing.
Of course, not all debt is good debt. At every stage of business growth, it must be handled with care. Brand new companies are particularly prone to misusing and misunderstanding debt financing. Faced with startup capital needs averaging somewhere between $10,000 and $80,000, some new business owners dig themselves into a financial hole. While they don’t qualify for small business loans, these businesses can rely too heavily on credit cards (sometimes their personal cards!) or fall prey to predatory lenders.
Debt alone can’t kill a business, but it can hasten its demise. Responsible lenders review a business’ financial state to decide how much capital it needs and how much debt it can handle. They know that debt financing done wrong has the power to set back a small business, just as smart debt financing has the power to push it to the next level.
Myth #3: Equity is better than debt
In a world of tech startup legends, equity is decidedly more glamorous than debt. “Angel investor” certainly sounds more interesting than “term loan!” But not all entrepreneurs seek equity financing, nor do all businesses offered equity take it. Let’s take a look at the reasons why business owners may choose one form of financing over the other.
The benefits of equity
Equity financing is essentially the sale of a percentage of your business. In exchange for their capital, an investor takes ownership of a piece of your business. It’s a long-term business partnership. While equity can be difficult to secure and make decisions and accountability a lot more complex, there are definite benefits.
- New businesses with no revenue or profitability may receive equity financing
- The business owner incurs little to no risk
- No percentage or revenues go to paying back loans
The benefits of debt
Debt financing is a temporary, transactional relationship between a lender and borrower. While irresponsible practices on either side can lead to trouble, debt has many benefits over equity for many small business owners.
- There are many types of debt, from small business loans to MCAs, covering many types of businesses
- The business owner does not need to share profits or decision-making with others
- Repayment terms are clear
- Interest rates on loans are generally lower than returns on equity investments
- Interest on debt is tax-deductible
Your business cannot thrive without financial health. Educating yourself on the truth about debt financing is an important investment into your company’s wellness.