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Overview of Debt Financing

written by: •edited by: Michele McDonough•updated: 6/1/2011

Some businesses and companies use debt financing as a way to help get their businesses off the ground and to help their businesses grow. Find the answers to the questions, what does debt financing mean and how does debt financing work in this informative article.

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    Financing a Business Through Debt?

    As you may know, there are many different ways that one can finance a business. For example, one can take out a loan or look for investors for your business, borrow from your 401k plan, or take out a mortgage on your house. When researching all the possibilities for funding a business start-up or for funding business growth, the term, "debt financing" may come up.

    Debt financing means that you have borrowed money to help you run your business. This money, rather than being borrowed against equity you have in a home, 401k plan, or even your own business, comes from an outside source such as a bank, another company (that wants to be paid back rather than take a share of your profits), or a friend or family member. Debt financing also means that in most cases, when you pay back your lender, you will also be paying a pre-agreed upon interest rate.

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    What Avenues Are Available for Debt Financing?

    The most common source of debt financing for a business is a bank. Banks offer a structured payment plan, standardized interest, and sometimes fees associated with taking out a loan. Naturally, when you borrow from a bank to fund your business start-up or expansion, you will be subjected to a credit check, and you will need a way to prove you can pay the money back.

    There are two types of debt financing: recourse and nonrecourse debt financing. Recourse debt financing requires that you make a personal guarantee securing the loan. If you default on your loan (do not make the agreed upon payments), then you will those items that you had securing the loan. Nonrecourse loans are set against real estate or equipment, and should you default on this loan, you may have some objects repossessed and sold off in order to repay the loan.

    The following are different forms of debt financing you may find yourself interested in:

    • Savings, Personal Contacts, Credit Cards
    • Mezzanine Financing
    • Banks
    • Government Sponsorship
    • ABL's (Asset-Based Lenders)

    Before you look at debt financing as an option for your business, it will be important for you to understand both the different kinds of debt financing and the advantages or disadvantages of them.

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    Debt Financing Through Savings, Personal Contacts, or Credit Cards

    If you need money for your business, and you need it now, these three means of financing, while often overlooked, can be the first place to look. Financing your business using personal savings (and paying back what you borrowed) can be a great option if you believe that you are disciplined enough to actually pay the money back in a timely manner.

    A second option, when you need money for your business, is to borrow money from friends or family. While there are some disadvantages to this, the main advantage is that you are unlikely to have to jump through the hurdles to borrow money you would otherwise need to jump through to borrow through other means. Make sure to draw up an official agreement with the friend or family member stating how and when the borrowed monies will be paid back.

    A third option is to finance your business needs through credit cards. Be very careful about using any personal credit, especially credit cards, to finance your business. Credit cards often charge a very high interest rate. They also allow you to easily spend more than you can afford to spend at the swipe of a card. While you will not have to wait for the approval of a loan, or even draw up a business plan to fund your business this way, your business could fail because of it.

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    Debt Financing Through Mezzanine Financing

    Mezzanine financing is another type of financing, that is a combination of debt and equity financing. This is a type of debt financing that you would use to finance a company that already exists for expansion or growth. Mezzanine financing involves the lender securing the loan with equity-based collateral such as a business share. Should you default on a mezzanine loan, the debt provider would take ownership of your business or part of your business. This is another means of financing your business, with relatively little paperwork, and a high interest rate.

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    Debt Financing Through Bank Loans

    Obtaining a loan through a bank is one of the most traditional ways to fund a business through debt financing. There are a variety of loans you can obtain. When obtaining a loan through a bank, you will want to be absolutely sure you understand the repayment terms. Different banks can have different terms. Know what your interest rate will be, know what your closing costs will be, and know what your penalties for late payment might look like.

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    Government Funding Through SBA (Small Business Administration) Loans

    An SBA loan is sponsored through the government, and while there are different types, generally the most you can obtain through this method of financing your business is $150,000. SBA Loans are another type of popular debt financing for owners of small businesses. There are a few different types of SBA loans you can apply for. The 7(a) Loan program guarantees financing for small business startups and existing businesses. The CDC/504 Loan is a long-term, fixed rate loan that allows the recipients to purchase assets such as real estate and equipment. Microloans provide small (only up to $35,000) loans for the purchase of supplies, machinery, fixtures, or inventory. Finally, disaster assistance loans are low-interest and they help individuals to replace items lost in a declared disaster.

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    Asset Based Lending

    Debt financing of this type is secured by some asset owned by the business. When the loan defaults, the lender takes possession of the asset that served as collateral during the term of the loan. This is probably the last resource, unless for a mortgage, a business should turn to for debt financing.

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    So...What Does Debt Financing Mean?

    After reading this article, you should now be able to answer the question, "What does debt financing mean?" Debt financing is the means of funding a business startup or expansion through taking out a loan or other credit line from an individual or institution that will be paid back over a determined time period with a determined pre-set interest rate. As undesired as being in the red is, debt financing may be necessary to get a business off the ground or to help the business expand into new markets. Before using debt financing to fund your business, it is important to take all facts into consideration. How will you pay back the loan, over what time period, and how much loan can your business really afford? By providing honest answers to these questions, you can ensure that debt-financing your business will not lead to the death of your business.