Entrepreneurs fresh in their industry are typically starting out behind major players who are dominating the sphere. To get their businesses off the ground, they need to raise funds, with these coming from a variety of potential acquisition methods. Presumably starting out with not a lot of financial armor, many entrepreneurs have realized that they can get the financing they require by taking on some debt. This is a practice commonly known as debt-based fundraising.
This may sound counterintuitive, but it’s best to think of this situation as borrowing money from a source with an agreement to pay that money back with interest. Banks are the most common lenders, but they are not the only sources available to business owners trying to get their business off the ground, or to keep it solvent.
Before fundraising in some manner, it is important to consider the benefits and pitfalls of taking this approach. Borrowing money with the promise of paying it back is how you end up accruing debt; but while being in debt has a frightening connotation to it, it may help a business out in both the short and long term.
Let’s consider some of the advantages and disadvantages of debt-based fundraising for your business. Let’s start with the pros.
When you borrow money to pay for your business, it forces you to plan on how that money will be spent and how it will be invested. Most importantly, it pushes the borrower to come up with a repayment plan. As the principal and interest have to be paid out monthly, the borrower will know exactly what they will owe for a repayment monthly, taking the guesswork out of monthly financing.
Finding an investor may work for some businesses; but with that option, part of your business is essentially not yours. If an investor (or a group of them) ponies up the funds for your finances, they rightfully have a say in what you do and how you run your operation, at least to a certain degree. While this might be a popular option, it’s important to consider that when you take on debt, you have the responsibility to repay it. However, you will then get to make decisions about how that borrowed money is utilized, giving you maximum control over your own business, rather than the insistence of a benefactor who may not agree with your methods.
The investors will also expect some ROI going forward from your business’s future earnings. They would argue that without their funds, the chances of getting your business off the ground are slim, thus entitling them to future profits. This is a concern that borrowing, by incurring debt that you will ultimately pay off, would eliminate.
Tax Deduction Benefits
Since most loan interest counts as business expenses, they can be deducted from income taxes. As the interests paid with the principal are tax-deductible, entrepreneurs get a tax-based advantage by reducing how much they will ultimately owe during tax season. It is not surprising, therefore, that taxes are a consideration when deciding on the type of debt to incur.
While those are some great advantages, it is important to look at the less desirable attributes of debt-based fundraising.
The debt accrued can go a long way in helping your business, but at the end of the day, it must be repaid. This repayment can be planned; however, the terms of the loan are not going to change even if the business is not doing as well as you had hoped, and you’re still liable for the monthly payments. Even more concerning, if your business fails, you are still obligated to pay off the debt. In the event that bankruptcy is declared, loan lenders will have prime priority, surpassing any investors who will also likely be looking for compensation on their investments.
Credit Score Impact
Every loan taken out is noted on your credit report. If you take more than one loan out, every additional loan increases the chance that you won’t make your payments on time (or at all). This raises the risk that you pose to the lender, who will be rightfully nervous that they will not be repaid. This will trigger them to try to offset such risks by increasing the interest rates. That means that even if you can pay off all your loan principles, the interests alone are going to tag on a hefty sum to your debt totals.
The higher the impact on your credit score, the harder it becomes to acquire additional loans too. A good credit rating is an essential component of getting more loans.
To ensure that they will get their loan paid back in one way or another, lenders request that business assets are put up as collateral. This puts you at a higher level of financial risk. If you miss payments or are late, the impact on your business could be significant. The lender may also request a binding guarantee of loan repayment, which could be tough to accommodate if your business were to go under.
Debt-based fundraising certainly offers some freedom, tax benefits, and peace of mind in terms of ownership control, but it is important to remember that incoming funds are not free. There are still debts that you must pay back regardless of whether your business is booming, remaining solvent, or failing.
What other pros and cons of debt-based fundraising are there? Let us know in the comments!
This article originally published on GREY Journal.