In financing, the risk reward trade-off holds true; the greater the risk the financial resource is taking, the greater the return they are expecting to receive from their investment. Understanding where your company and your financial resource are on the financing spectrum will help you determine if there is a good match between debtor and creditor.
Debt vs. Equity
One of the first questions you need to ask yourself when determining your capital requirements, are you willing to give up some ownership or control of your company? If you are, than you may be a candidate for equity financing, if you are not, then you are more likely a candidate for debt financing. In general, with debt financing, there is a clearly defined: loan amount, interest rate and term, and you are required to make periodic fixed principle and interest payments over the term of the loan whether your company is profitable or not. However, the financing resource does not have ownership of your company or the ability to directly control the direction of the company. In general, with equity financing, there are no fixed periodic principle and interest payments, and there are no fixed terms as to when the investment needs to be paid back. However, in return for their investment, you give the investor, an ownership stake in the company, a share of the company profits, and the ability to control the overall direction of the company.
There are many types of debt financing including: loans, lines of credit, factoring, and purchase order financing.
Loans are typically used for financing the purchase of fixed assets such as buildings and equipment. They are generally provided by banks and finance companies, have a fixed term 3+ years, a fixed annual interest rate, and a fixed monthly principal and interest payment. They are typically secured by the fixed asset being purchased. Loans are typically made for 50% – 80% of the value of the fixed asset being purchased. In general, this type of debt financing is usually provided to companies that are breakeven or profitable and have been in business for 3+ years. Interest rates currently range from approximately 7% to 12% per year.
Lines of Credit
Lines of Credit are typically used for financing working capital needs and are used on as needed basis. They are expected to revolve on a regular basis, that is, you borrow money one month then pay it back with interest the next. They are generally provided by banks and finance companies and have: an upper limit of dollars that can be used at one time, a fixed term of 1 year, a variable annual interest rate, and a variable monthly payment depending on the amount of funds being used. They are typically secured by such things as accounts receivable and inventory. In general, this type of debt financing is usually provided to companies that are breakeven or profitable and have been in business for 3+ years. Interest rates currently range from approximately 7% to 12% per year.
Factoring also used for financing working capital needs, is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor or finance company) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables (essentially a financial asset), not the firm’s credit worthiness. Secondly, factoring is not a loan, it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three. Factors usually factor a limited number of invoices, for a limited time (30-60 days), and charge a fixed interest rate which ranges from 1%- 3% per 30 days and is collateralized by the accounts receivable. Invoices may be factored with or without recourse. In general, this type of debt financing can be provided to new and established businesses.