Whether you are a first-time entrepreneur or a seasoned one, whether your business is still in its infancy or has flourished enough to make a profit, funding is the main ingredient that runs an enterprise. And to do that successfully, a constant flow of money needs to be ensured by the entrepreneur. While some entrepreneurs choose venture capital funding or equity financing for this purpose, others depend on raising debt financing, or a hybrid of both.
Equity Financing Vs Debt Financing
For the funding to happen smoothly, an entrepreneur should know about different means of raising money and compare them. When it comes to equity financing, the entrepreneur gets funds against company equities, while debt funding is a kind of lending where company bonds are sold to the investor to get the loan.
The entrepreneur can also source funds with a hybrid of debt financing and equity financing, which is called ‘hybrid’. In this case, the startup gets some of the money by providing company equities to investors and the rest by selling bonds. Thus, the total valuation of the company becomes the value of bonds and value of equities. The investors, on the other hand, earn interest on the debt funding and dividends from returns for equity financing. In the case of hybrid funding, since the entrepreneur has to pay back interests, the startup earns profit only when the returns are greater than the interest payment.
Key Concerns In Raising Debt Funding
But raising debt funding surely has its own sets of advantages and disadvantages that the startup needs to keep in mind while making its choice. Hence, to make that choice wisely, one needs to know how to raise debt financing.
Raising debt funding is done by selling company bonds. Debt financing is done by an investor or a venture capital firm by lending money to the entrepreneur, for a certain period, at an interest agreed upon by both the parties. For this purpose, the bond is issued to the investor, which acts as the certificate for the loan. Unlike venture capital deals of equity financing, here the entrepreneur has to pay back the amount borrowed within a pre-scheduled date, along with the interest payment. The investor might put forward some terms and conditions and termed covenants upon the debt fund, but can’t acquire rights in the company they lend money to, as is the case in equity financing. Raising debt financing is, thus, profitable in a sense that the entrepreneur retains their autonomy over the startup or enterprise and can freely choose and implement strategies to function and operate the business. The investor’s role, therefore, is limited to money lending and repayment only, and they can’t interfere in the decisions and strategies of the business.
In raising debt funding, a major concern is the high rate of interest associated. This is done to protect the investor from incurring losses in cases of business failures and company closures. The higher the lack of confidence in the entrepreneur’s repayment abilities and success of business strategies, the higher is the interest rate. This is the reason that first-time entrepreneurs raising debt funding for startups are often levied higher interest rates.
Another issue is the securities kept against raising a debt fund. Just like loans, here also the investor provides the debt against the company or the entrepreneur’s assets, kept as security. In the case of non-repayment of debt within the stipulated period, the investor or bank can seize the assets to recover money. Moreover, in case the company goes bankrupt, the debt funding investors are the first people to get their money back by selling off the business or its assets. Thus, raising debt funding for business can be useful only if the investor has enough assets and the conviction that the startup will succeed.
When To Raise Debt Funding
Raising debt financing requires identifying the needs of business and areas of expenses properly before the entrepreneur approaches the investor. This is important because there are different types of debt funds available to opt from, based on diverse needs. There are two types of debt financing – long term and short term. Long-term debt financing is applicable to bulk fund requirements or capital costs of infrastructure, setting up the business, the additional capital requirement for market expansion or upgrading to meet business growth or product development and diversifications. Therefore, raising debt financing for the long term comes with a repayment period of more than one year, assets requirement as security and a relatively higher business rate.
Raising debt funding for short term is helpful in bearing costs of a business like rent or maintenance payment, salaries of employees, buying raw materials, etc. These debt funds usually have a repayment period of maximum one year and are associated with lower interest rates and no or minimal collateral requirement. In order to raise debt funding and utilise it effectively, the startup needs to focus on the nature of its finance requirements to avoid risking assets or paying unnecessarily high interest.
What’s The Cost Of Debt Funding?
Learning how to raise debt financing also includes proper knowledge of the sources of debt financing and the loan terms. There are individual investors, banks, NBFCs and big business or investor groups in the market who provide debts to the business at different terms and conditions, rates of interest and collateral requirements.
Venture capital firms also include debt financing in their investment portfolio to invest their funds efficiently and earn good returns. To pick the right investors for raising debt funding, the entrepreneur needs to do proper background checks for credibility and market reputation, carefully consider the terms and conditions and compare the interest rates and collateral requirements.
Moreover, the entrepreneur needs to be aware of the cost of debt financing and its measurement. Since debt financing is basically a loan, the investor here earns interest against the fund investment. This annual interest payment, termed as coupon payment, is, therefore, the cost of borrowing or debt financing. Here, the interest rate is usually tax-deductible.
To calculate the cost of debt, a company must determine the total amount of interest it is paying on each of its debts for the year. Then it divides this number by the total of all of its debt. The cost of debt is the interest rate multiplied by (1 – tax rate).
Measurement of debt financing, on the other hand, refers to the debt to equity ratio (D/E) of the company. Hence, a lower ratio is generally preferred by a company as it implies lower interest payment made, compared to the returns earned, thereby reflecting a profitable situation.
But to raise debt funding and make it work, the first and foremost requirement is convincing the investor about the deal. And for this, the entrepreneur needs a solid business pitch or a clearly defined strategy for business growth. Thus, before approaching the investor or offering a deal, the founder or startup need to conduct thorough market research and study the business plan to present the extensive data, documents, balance sheets and figures that support the vision of a successful business. The rest is, of course, the marketing ability of the founder or promoter, which must also be on point!