Debt financing is a way through which startups or businesses raise funds or capital by borrowing from individuals or organizations. The funds raised by these startups or businesses come as loans; some common examples of debt financing are soft loans, term loans, convertible debts, and guarantees. Every type of debt financing has advantages and disadvantages, and making the right choice for your company requires knowledge of the different types which are discussed below.
Types of Debt Financing
- Installment loans
- Cash flow loans
- Revolving lines of credit
- Guarantees (bonds, notes, and bills)
Types of debt financing are simply the categories or classifications of the different types of debt that a business or startup may use to raise funds such as selling its debt instruments such as bonds, notes, bills; or others.
Installment loans are very similar to other types of debt financing such as car loans or mortgages; however, instead of paying back the full amount all at once, you make monthly payments over time until the full cost is finally paid off. The reason this type of debt becomes attractive is that it only requires one initial payment and then smaller additional ones thereafter due each month.
Installment loans can be ideal for people who want stable monthly payments and prefer repaying their loans over extended periods. If you manage your cash flow well, these types of loans could provide you with enough time to repay the borrowed amount in installments. You should also think about using an installment loan if your credit score isn’t perfect but still good enough for qualifying for personal loan products.
Cash flow loans
In this type of debt financing, the lender checks for the cash flow of the business and then makes a decision as to whether to give the credit or not.
Typically, lenders make an assessment based on the ability to repay the amount as well as ensure that they will be able to easily sell off any existing equipment or property owned by their clients if repayment does not come through. This helps them minimize their losses should the borrower default on repayments; this technique can be helpful, especially when dealing with small-medium enterprises that have just begun to grow.
A cash flow loan can be given based on the following criteria:
- The debtors’ current financial state: This is usually determined by their available liquidity, which is how much money they have in their account right now.
- Their credit rating: A client or debtor with a good credit rating will have a much better chance of being granted a loan, as they have shown that they are able to repay the debt.
- The company’s current cash flow position.
Revolving lines of credit
A revolving credit facility (RCF) or line of credit, is a loan agreement that allows the borrower to draw upon the line at any time up to an agreed limit. The purpose of this type of financing is to provide additional working capital for short-term cash flow fluctuations. It’s considered “working capital” because it has no impact on a company’s earnings per share (EPS).
It can be helpful for companies that have high revenues but unpredictable expenses since they are not required to pay back the full amount drawn under the agreement each time they access funds. This financial tool can also be used as a risk management strategy for seasonal businesses that experience major swings in business activity throughout the year.
Guarantees are used to protect creditors who may face unexpected credit risks. A typical example is when governments issue bonds to finance loans which allow them to raise money for projects such as roads and bridges. The examples below outline how guarantees are used for debt financing:
- Federal government’s debt financing through Treasury bills which are short-term debt obligations that mature within a year or less.
- Another example of the use of guarantees for debt financing is the federal government’s issuance of Treasury notes which are medium-term debt securities that have a maturity ranging from more than one year up to ten years.
- Lastly, an example of long-term borrowing by governments is through the issuance of bonds that have maturities over ten years with most having very few or no repayments before maturity.
Examples of Debt Financing
- Bank loans
- Loans from family and friends
- Government-backed soft loans, such as SBA loans;
- Equipment loans
- Home Equity Lines Of Credit
- Credit cards
- Monthly Recurring Revenue (MRR) loans
- Merchant Cash Advance
Examples of debt financing are simply the specific or individual debts that fall under any of the types of debt for financing a business; each business is unique in its own way. Some examples of debt financing may be suitable for a specific type of business such as startups while others may be suitable for small or medium-sized businesses.
The type of business that finds it easier to get debt financing is a large established business or business corporation because it has an established source of revenue, assets, and good credit history, hence commonly favored by lenders.
A bank loan is an example of debt financing whereby the bank lends money to the borrower for a certain time period with interest charged on it. The disadvantage of taking bank credit is that if your project fails then you will be considered a default and other banks will also consider you a bad creditor
Loans from family and friends
Loans from family and friends are a great way to finance your business or other ventures. They can be a fast and easy source of financing, but they also have their share of risks. These types of loans are exactly what they sound like; they’re personal loans that you get from people close to you, such as family members or very good friends. These generally have lower interest rates than traditional bank loans.
In this example of debt financing, the government offers loans of varying interest rates and payment plans to small businesses such as the United States Federal Government’s Small Business Administration (SBA) loans. This is a type of soft loan that is unsecured and usually has flexible terms and repayment periods. Examples include the United States Federal Government’s Small Business Administration (SBA). The SBA offers small businesses loans ranging from $500 to $5 million dollars with varying interest rates and payment plans.
Mortgages are examples of debt financing which is an individual or corporation needs to purchase a property. In this type of lending agreement, the borrower uses the home they want to buy as collateral to secure repayment from the lender.
This is an example of debt financing in which the capital raised is used for the purchase of machines and equipment for the operations of the business.
Home Equity Lines Of Credit
A home equity line of credit (HELOC) is a loan that provides you with access to money against your home’s equity as collateral. You get this just like any other type of credit, but instead of getting a large sum all at once or using it for one specific purpose, you can use your line of credit whenever and however much you need. As long as the balance doesn’t exceed the value of your home, and you’ve paid down enough principal on the account to meet some threshold, usually 80%, lenders will allow you to borrow from the line again.
They are unsecured revolving lines of credit and are used to borrow money, the borrower of the money is referred to as a ‘Cardholder‘. The credit card issuer of the loan is referred to as an ‘Issuer‘. The credit card amount of credit varies widely between issuers.
Monthly Recurring Revenue (MRR) loans
Monthly recurring revenue models are a relatively new approach in the venture capital industry. The purpose of these models is to provide a simplified method for startups to finance their growing businesses in a way that could be achieved even with limited resources or funding. Under this model, strategic investors usually offer companies monthly payments over several years based on the monthly earnings growth after paying all expenses.
A merchant cash advance (MCA) is similar to an invoice factoring arrangement. A business applies for an MCA; the lender
In other words, the investor assumes all risks and only pays when there is clear evidence of cash collection from customers. As well as making an investment in exchange for equity shares, the investor takes responsibility for providing financial guidance and mentoring.
Merchant Cash Advance
A merchant cash advance (MCA) is similar to an invoice factoring arrangement. A business applies for an MCA; the lender makes a determination of how much the business can reasonably afford to repay over time, and offers the business a loan based on that amount.
Some lenders may also offer line-of-credit MCA’s instead where they extend credit similar to revolving credit lines extended by banks, so it’s important to understand if you are being offered what type of MCAs. The main difference between an invoice factoring arrangement and a merchant cash advance is that in order for the loan to be approved, there must be at least one month’s worth of sales history with which this particular lender is comfortable.
Microloans are small loans that help people lift themselves out of poverty through small business initiatives. The purpose of a microloan is to provide people with enough money so they can become more self-sufficient and contribute to their family’s financial stability. Lending Club and Kiva, are two major organizations that offer microloans.
What are some examples of debt financing?
Common examples of dent financing include loans from family and friends, equipment loans, Government-backed soft loans, such as SBA loans;
What are three general types of debt financing?
The 3 general types of debt financing are secured loans, unsecured loans, and lines of credit.
Nansel is a serial entrepreneur and financial expert with 7+ years as a business analyst. He has a liking for marketing which he regards as an important part of business success.
He lives in Plateau State, Nigeria with his wife, Joyce, and daughter, Anael.