Funding is one of the key factors which determines whether a startup will take off successfully or if its growth will stagnate. Getting funding for young businesses is a challenge which most young entrepreneurs struggle with. Since the business is not old enough, it always becomes difficult to prove to investors and creditors that the business has growth potential.
There are two main types of funding which a young entrepreneur can opt for. The first one is equity financing where the entrepreneur relinquishes a certain percentage of ownership and control of the business to an investor in exchange for business funds. The other one is debt financing where the young entrepreneur seeks financing from external sources and pays such a debt over a period of time, usually with interest.
The Advantages
1. Tax Deductions
The interest charged on loans is tax deductible. This is unlike the dividends paid to shareholders. Thus opting for debt financing will reduce your tax obligations to some extent.
2. Retention of Business Ownership
With debt financing, you finish off with the financiers once you pay all the outstanding loan plus interest. These financiers will thus not have a say or control in the way you run your business. This is not so with equity financing. If you opt for equity financing, you will need to permanently relinquish certain percentage control of your business and share the business profits with the investors.
3. Can Increase Credit Rating
It is true that if you take several loans all at once, your credit rating will be affected negatively. But if you manage to pay these debts in time, and clear your company name from the debt list, your credit rating will rise significantly. Crediful advises young entrepreneurs to ensure that they grow their credit rating as this will affect their ability to take larger loans in the future. To achieve higher credit rating, ensure that you pay your loans in time, get expert advice even before procuring the loan, and negotiate to get loan repayment terms which you are comfortable with.
4. Debt Financing Can Fuel Growth
If you take a loan to buy equipment, purchase real estate, or even increase the number of employees, your business is bound to grow. But this is not always the case. Ensure that you have the right business strategies in place to increase the possibility of success and minimize risks and uncertainties.
The Disadvantages
1. May Impact on Credit Rating
Taking a loan and failing to pay it in time will likely translate to lower credit rating. If your projected business plans did not go as you expected and you are forced to refinance your business, such supplementary loans will only serve to lower your credit rating. Therefore, it’s important to gauge the worst case scenario and prepare in advance.
2. Needs Collateral
Loans, especially from banks and other financial institutions usually require collateral as a guarantee of repayment. This collateral could be a piece of equipment, a piece of land or even business inventory. Such a requirement could be a big derailment in getting the desired amount of loan from your financial institution.
If you have a lower-valued collateral, then getting a big loan which does not equate to the value of the collateral is difficult. You can get around this challenge by borrowing informally from friends and those close to you. But the level of financing you can get from this arrangement is usually limited.
3. Reduced Cash Flow
Taking a loan implies that you will commit yourself to make monthly repayments to the financial institution which advanced the loan to your business. If you are repaying several loans, the cash flow will be impacted negatively and you may find yourself lacking sufficient cash to run the day to day activities. It’s, therefore, important to gauge your loan repayment ability before agreeing to the loan repayment terms. If the repayment terms are not favorable, negotiate with the financier until you get a win-win situation.
4. Stringent Qualifications
Financial institutions exercise a high level of caution when lending money. This is in an effort to reduce risks and possible loss of the lenders’ capital. They, therefore, have laid down prequalification conditions for you to be deemed fit to get a loan. These conditions are even more stringent for startups and those businesses which don’t have a long financial history.
Debt financing is important as it can help fuel business growth. It’s one of the top means through which young entrepreneurs get their business off the ground. Like any other form of financing, it has its advantages and disadvantages. It’s important, therefore, to evaluate both the benefits and drawbacks before choosing it as a means of financing your business.