Advice

Expanding Your Business – Is Debt Financing Right for You?

It’s an exciting milestone when you’re ready to expand your business! You may want to purchase or lease equipment, upgrade furniture and fixtures, or obtain working capital. Whichever it is, you may need financing to realize your expansion plans. But which lending option should you pursue? Some companies may be able to issue stock, while for others a loan may be a better fit. But even then, do you get a conventional or SBA-guaranteed loan? What if you have a collateral shortfall? Choosing the right type of small business financing can mean the difference between reaching your goals, or falling short.

Debt and Equity Financing

Two ways to meet your need for capital:

  • Debt financing is borrowing from a lender and paying the money back with interest over time. It includes conventional bank loans and lines of credit, as well as SBA-guaranteed loans and lines.
  • Equity financing is selling partial ownership of your business to investors in exchange for funds. This does not need to be paid back, nor do you pay interest. However, you give up some control and potential future profits.

Pros and cons of debt and equity financing include:

Debt

  • Pros:
    • Retain full control of your business
    • Interest you pay may be tax deductible
    • No obligations to lender after you fully repay the loan
  • Cons:

    • Adds a monthly payment on top of expenses
    • Must be repaid within a certain timeframe
    • If you don’t repay the loan, you may lose assets you’ve pledged as security

Equity

  • Pros:
    • You do not have to pay the money back
    • No monthly payments, including no interest
    • Investors assume the risk for return on their investment
  • Cons:

    • Lose partial ownership of your company
    • Must consult with investors before making decisions
    • Longer timeframe needed for funding1

Debt Financing – Five Key Criteria for Lenders

There are five critical criteria that lenders review for debt financing. These are known as the 5 C’s of credit. While specifics vary among institutions, the 5 C’s provide a framework that helps lenders decide whether or not to offer you a loan or line of credit.

  1. Creditworthiness – your trustworthiness, shown through your track record of paying back creditors. Lenders will review your credit report and credit score – both personal and for your business. They want to see you’ve consistently paid back your debts as agreed and on time. Higher scores on your credit report mean they take on less.

  2. Cash flow – your ability to pay back the loan. To assess this, lenders look at your cash flow and other financial statements. They also compare your debt to your income through a debt-to-income ratio. The lower the ratio, the more money is available to make your payments.
  3. Capital – how much money you’ve invested in the business, including assets. Lenders are more willing to provide financing to someone who has “skin in the game.”
  4. Conditions – the current market and industry in which your business operates. It also includes how you plan to use the money, and the length and size of the loan. To evaluate their risk, lenders will look to outside forces. These can be the direction of the economy, the state of your industry, or what’s happening in your geographic area.
  5. Collateral – business and personal assets that secure the loan. Examples include equipment, inventory, accounts receivable, and real estate. Collateral provides lenders with assurance – if you don’t repay the loan, they can sell the collateral to get some or all of their money back.2

Have a collateral shortfall? Consider Small Business Administration (SBA) financing

Your business may perform well in four of the 5C's, but lack collateral. In this case, applying for an SBA-backed loan may be your best option. Rather than lending directly to businesses, the SBA sets guidelines for its lending partners. SBA loans provide other attractive benefits, such as lengthy repayment terms (up to 10 years) 3 and competitive interest rates.

It’s important to have a strong business plan that shows how the funds will be used and profits generated for repayment. If you don’t have a business plan and would like to develop one, you can seek help from a Small Business Development Center or SCORE Association chapter. They may also assist you with providing three years of financial projections that lenders will want to review.

Choosing the Right Financing for Your Business – We’re Here to Help

If you’d like to explore what debt financing could mean for your business, give us a call. Our experienced lenders will be happy to answer your questions and discuss financing options with you. Or learn more at emprisebank.com/business/borrow/sba-loans

 

Sources

1 https://www.entrepreneur.com/article/278430

2 https://www.fundera.com/blog/5-cs-of-credit

3 https://www.entrepreneur.com/article/309471

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