What are the Disadvantages of Being Debt-Free?
It’s only natural to assume that carrying no debt is safer than carrying manageable debt. But believe it or not, being debt-free creates several disadvantages. Here are a few reasons why being debt-free isn’t necessarily a good thing for all businesses:
1. Lower Credit Score
Excellent credit doesn’t just come from making payments on time. You must also have an impressive credit utilization rate based on how frequently you borrow funds and how much credit you use. This is why people who only have one credit card and pay it off in full every month don’t always have the best credit scores.
According to Forbes, a credit score of 780+ is typically assigned to someone with a utilization rate of around 5.6%. A credit score below 600, on the other hand, probably belongs to someone with a utilization rate of 77.2%.
In summary, you cannot attain excellent credit without multiple forms of debt. And you can’t obtain the most advantageous business loans and credit cards on the market without excellent credit.
2. Equity Financing Has Its Downsides
Businesses that forego debt financing often pursue equity financing instead. Equity financing may seem like a better option since you don’t have to pay anything back. However, you have to give up a piece of ownership, and you might only be able to use the money for specific purposes. These are just two of the many disadvantages of equity financing, which we’ll go over in more detail later on.
3. Fewer Tax Deductions
One of the most significant advantages of business loans is that interest payments are tax-deductible. Let’s say you and your competitor are neck to neck in terms of profitability. You have financed your business with a small business loan, whereas your competitor has used investors. Come tax season, you would probably win the profitability race after deducting your interest payments.
4. Fewer Funds to Cover Sudden Expenses
Unforeseen expenses are an inevitability in the business world. Sooner or later, every business will need to come up with a substantial amount of cash at a moment’s notice. If you used your own money for this purpose, you might have to pass up a rare but lucrative opportunity that comes your way. And what if you get hit with a second curveball? It’s tough to obtain business loans with a low bank balance.
When you cover unforeseen expenses with a business loan, you still have your savings. You wouldn’t have difficulty getting approved for a second loan. Businesses must maintain a decent bank balance should the need for additional funding arise.
How Can Businesses Avoid Getting into Too Much Debt?
No rule book says what you can and cannot finance with debt. This is another reason unmanageable debt is so typical. Thus, rather than focusing on specific expenses, business leaders should focus on keeping an eye on their debt and using the right debt financing tools.
Here are a few ways to prevent your small business from taking on too much debt:
1. Regularly Fund Your Business Bank Account
Rule number one for avoiding unmanageable debt is funding your business bank account during every pay cycle. You take a fixed percentage of your own income and put it into the account. The more money you put away, the more cash you have to spend instead of taking on more debt. How you use this cash, however, is up to you. Some people like to use it to cover certain minor recurring business expenses, like hosting for their websites or their accounting system membership fee. Others prefer to only dig into this money for significant expenses, like a plane ticket for an upcoming conference.
None of this is possible, however, unless you separate your business and personal finances. Even opening a separate personal account and treating it like a business account is better than keeping personal and business finances in one bank account.
2. Use the Right Debt Financing Tools
The two most common debt financing tools are business credit cards and small business loans. While the latter option is typically more affordable, it makes more sense to finance certain recurring or one-time expenses with the former.
For example, it might make more sense to finance a large purchase with a business credit card that comes with 0% APR for 12 or 18 months. You could purchase at the beginning of the year and pay it off with no interest as long as you pay off the total within that period. Rewards programs are a significant factor as well. Some business credit cards give bonus rewards for business expenses like phone bills, Wi-Fi, office supplies, or airline travel.
3. Don’t Grow Too Fast
Businesses that take on too much debt in their early stages tend to have at least one thing in common: they tried to grow too fast. This doesn’t just refer to the speed in which they moved forward with a game-changing initiative. More often than not, growing too fast means moving forward without enough data to support their efforts. Before you have amassed a decent track record of ROIs, you need to take it slow and stay thrifty. Your only fixed expenses should be the bare essentials.
4. Cut Expenses
Debt makes you feel restricted. The quickest way to neutralize this feeling is to free up as much cash as possible. So, review your financial statements to determine which expenses you can cut or reduce. If your business is in serious jeopardy, you might just want to cut or temporarily suspend any expense that isn’t necessary for your business’s day-to-day operations. As for those necessary for your business’s operations, see which costs you can reduce or modify to your benefit. For example, a vendor that cannot offer a discount at this time might be able to provide a flat rate.
Even if there’s very little room for reduction in monthly bills, taking action to cut expenses is a huge step forward. At least you can stop worrying that you are overpaying for something you don’t need.
5. Talk to Credit Card Providers
Do you have a long history of timely credit card payments? If so, you may be able to negotiate a lower interest rate. Credit card providers are much more likely to grant these requests to businesses generally in good financial shape. Another option is a balance transfer, or when you transfer existing credit card debt to another credit card with a lower interest rate.
6. Eliminate High-Interest Debts First
The debts with the highest interest rates have the highest monthly payments. Hence, you should try to pay off these debts in full before any others. Instead of making minimum payments, calculate how much more than the minimum payment you can afford to pay each month. Once that debt is paid off, apply the same principle to the debt with the next highest interest rate. This strategy has proven to maximize long-term savings while simultaneously speeding up paying off multiple debts.
7. Take Out a Small Business Loan
One of the most common purposes of business loans is paying off existing debts. But before applying, you should first tackle the other items on this list. Showing you’ve exhausted all of the necessary measures to reduce debt will significantly increase your chances of approval.
If you are currently paying back multiple loans, you may be able to consolidate your loans into a single monthly payment with longer terms. Your monthly expenses will decrease without damaging your credit.
When Does it Make Sense to Take Out Multiple Business Loans?
Most business leaders would probably balk at the idea of taking out multiple business loans. But in some situations, paying off numerous business loans simultaneously is the lesser of two evils. Before we lay out these specific situations, let’s first establish which conditions you absolutely must meet even to consider taking out multiple loans:
1. Calculate Your Debt to Income Ratio
As you can imagine, multiple loans are not recommended for anyone who has already fallen behind on their debts. Well, what constitutes too much unpaid debt? You can answer this question by calculating your debt to income ratio. Someone current on all of their obligations should have a debt to income ratio of less than 40%.
Likewise, multiple loans are also not recommended for anyone who has fallen behind on their accounts receivables. Has one of your clients taken over 30 days to pay you? If so, you should collect this payment before taking out another business loan.
2. Check Your Business Credit
Your payment history mostly determines business credit with business lenders, vendors, and suppliers. Thus, falling behind on payments will damage your business credit as well as your access to business loans. So, check to make sure you have a solid payment history with all creditors before applying for additional business loans.
3. Make Sure You Have Enough Recurring Income
Lastly, check your financial statements to ensure you have enough recurring income to justify another monthly payment. The keyword in that sentence is “recurring.” If your cash flow is a little rocky, another fixed monthly payment could do more harm than good for your finances.
Good Reasons to Take Out Multiple Loans
Now, we can go over specific scenarios in which it makes sense to take out multiple business loans:
- Business expansion, property, and facility updates. Since you are reinvesting in the business itself, this is less risky.
- Taking on new business opportunities. Some things are too good to pass up, and you never know when you’ll have these chances again. Many entrepreneurs got where they are today by being in the right place at the right time.
- Hiring a skilled workforce. Your team is your most valuable asset. And great help is hard to come by. Therefore, it’s always recommended to invest in salaries, benefits, and training.
Wrong Reasons to Take Out Multiple Loans
On the other hand, here are some scenarios where it doesn’t make sense to take out multiple business loans:
- To cover operational expenses – If you can’t cover bills and payroll and already have a loan to pay back, don’t take out another one. Instead, talk to a qualified attorney and accountant about possibly filing for bankruptcy.
- You are not generating enough revenue – If your income has dropped or your losses have increased, it’s dangerous to take on another business loan. Get your finances in order first.
What Is Business Loan Stacking?
There’s taking out multiple loans, and then there’s business loan stacking. This mainly refers to taking on numerous business loans for none of the reasons mentioned above. You see, those reasons should theoretically increase your revenue to the point where you don’t need to keep borrowing money. Also, you’d be so occupied with the initiative at hand that you wouldn’t even be thinking about taking out another loan anytime soon.
Stacking usually means taking out multiple business loans, one after the other, just weeks or months apart. In most cases, the loans are on the smaller side (i.e., under $50,000). Before you know it, you’ve got four or five loans to pay off, and your business is in the same place it was when you started.
You can avoid this unfortunately common situation by being patient and learning from your first business loan experience. After taking out your first loan, take some time to observe the changes it brings to your revenue and cash flow. If you didn’t achieve your intended goals, you might be dealing with a strategic issue, not a funding shortage. Either way, you shouldn’t take out a second loan unless you know exactly how much more debt you can take while paying off the first.
Which Cash Flow Problems Can’t Be Fixed By Business Loans?
Strategic changes can fix specific cash flow problems. In these cases, taking out a business loan is like putting a Band-Aid on a broken bone. To clarify, all the funding in the world won’t prevent the following issues from damaging your finances:
1. Bad Pricing
You’re meeting your business plan’s sales and revenue expectations but still struggling to turn a decent profit. One highly plausible explanation is that you’re pricing your offerings too low. If you’re in a highly competitive arena like a restaurant or salon, trying to gain market share through low pricing is a common tactic. It may even succeed in the short term. But if your prices are too low, the revenue you earn from these sales will be dwarfed by the money you spend to make them.
2. High Overhead
High operating costs are a silent killer. At first, they don’t seem high at all. It’s not as if you can just look at your financial statements and spot one significantly larger expense than the others. Instead, you have to do some thinking. For example, if you run a restaurant, how much food are you throwing out each night? Does your provisioning process need a review?
Labor is a considerable portion of any business’s budget. Are you over-staffing? Are you hiring full-time employees when you could be outsourcing projects to independent contractors?
Rather than looking at the costs of expenses, think about what you could be doing differently with spending habits.
3. Long Sales Cycle
Business leaders often make the mistake of assuming that making lots of sales automatically puts their cash flow in good shape. They forget to look at the time it takes for the revenue to enter their bank account. The longer this time frame is, the less profitable the sale becomes. If all of your revenue comes in at the end of the month, most of it will likely go towards bills that are due simultaneously. In other words, you have no time to plug money back into your business.
You need to spread out your revenue and ensure that your customers pay you by specific due dates. This might mean sending multiple invoices per month or sending reminders to customers with less than perfect payment records. Otherwise, your profitability will remain stagnant and possibly even decrease.
4. Taking On Too Much Debt
Let’s say you need a $50,000 business loan to buy the extra inventory to meet an expected boost in demand. You find out you qualify for a $75,000 business loan, so you take it. But what are you going to do with that extra $25,000?
If you use it to buy more inventory, there’s a chance that these items will go unsold. This is another prevalent cause of cash flow problems. The longer inventory sits on your shelves, the less profitable it becomes. You continue spending money on other expenses throughout this time frame while earning nothing from these items.
In summary, don’t borrow more than you need. This habit goes hand-in-hand with high operational costs. You can only allow it to go unacknowledged for so long.
5. Changes to Your Industry
When you started your business, you had your expenses and profit margins under control. Then things changed, and perhaps your audience has new demands. Maybe your supplier raised its prices. It’s up to you to modify your business model to adapt to these changes.
We’ve repeatedly mentioned that business loans cannot make up for strategic problems. They can, however, help you acquire the necessary resources for adapting to a new environment. So, if you take out a business loan for this purpose, make sure you are also changing your strategy to ensure your business’s long-term survival.
How Much Money Should Businesses Have Saved Up?
One of the most common culprits of business failure is the lack of a “rainy day” fund. This is why veteran business leaders are continually urging younger entrepreneurs to put as much money away as possible. However, it’s challenging to do this when you don’t have a clear picture of how significant this emergency fund should be. Vague goals are always harder to achieve.
Here’s how to figure out how much money you should save up in the event of a crisis:
Business Expenses + Personal Expenses
The first step is fairly obvious, and that’s figuring out how much money you typically spend on your business within the span of a few months. This includes all monthly business expenses as well as extra costs. Odds are, recurring bills and payroll aren’t the only things you spend money on every month. There will always be additional business expenses, so you can’t exclude them from your calculations. Though you may cut certain costs, it’s usually recommended to envision having to spend more money than less.
Also, do not look at monthly data from particularly busy or slow periods. Instead, base your calculations on how much your business spends in three to four average months. You may find that you have gradually been spending more money due to external circumstances like rising demand.
Here’s where it gets tricky. Your business is probably your sole source of income. If this is the case, you must calculate a few months’ worth of your personal expenses as well. Your personal budget would be affected in the event of a business crisis. Which personal expenses would you be able to cut back on? Which personal expenses would you still need to cover if your business earned almost no money that month? Since your personal expenses depend on your business, your emergency fund should be able to cover your business expenses in addition to your most critical personal expenses.
The Fragility of Your Market
Certain factors may make it necessary to set aside more money than the previous two calculations suggest. One example is the nature of your products or services. Does your business cater to a particular audience or fill a tiny niche? Is your business highly seasonal and, therefore, prone to elongated slow periods? The more diversified your business is, the less money you have to put away. Such companies have a logistically higher chance of continuing to earn a stable income following economic or industry-wide downturns. If anything, you’d just have to make some slight modifications to your products or services. Highly seasonal or specialized businesses, on the other hand, might want to set aside more money because their target market is more fragile.
Replacing Major Sources of Income
Let’s say your business has just lost a significant source of income. This could be a big buyer for a wholesaler, vendor for a retailer, or a restaurant supplier. How long would it take you to replace that resource and make back the money you’ve lost? Remember, you’re not supposed to be optimistic about these calculations. Most thriving businesses would likely need at least three months to replace a lost source of income. If you think it would most likely take more time than less to do this, your estimated emergency fund might need a boost.
How Much Would You Be Able To Borrow?
Some emergencies are so extreme that even the most financially careful business owners cannot cover the damage independently. Hence, when building an emergency fund, you should also consider how much you’d be able to borrow. You can figure this out by examining your credit score, how much working capital you usually have on-hand, and the ability to provide collateral. Supplementing at least a portion of your emergency fund with borrowed funds would be better for your personal finances than using only your own money.
How Can Businesses Avoid Defaulting on Business Loans?
“But what if I default?” said any business leader before dismissing the idea of a small business loan. Fear of defaulting likely stems from business lenders’ various measures to anticipate this scenario, like collateral or personal guarantees.
But avoiding default is as simple as following just a few steps. All of them involve the same general skills required for running a successful business. Thus, if you’ve already done this, you should have no trouble paying off a business loan.
Here’s how to ensure you never default on a business loan:
1. Make Sure You Truly Need a Business Loan
Any smart business leader can spot a lucrative or necessary investment. Is that new equipment or marketing campaign going to give you the boost in revenue you’re looking for? Do you need more workers to meet this recent surge in demand?
If someone defaults on a business loan, they usually take it out for the wrong reasons. Maybe they thought a strategic issue could be solved by more funding. Perhaps they mistook a more deep-seated, strategic problem for a “slow month.” Either way, the business did not have a revenue foundation that was solid enough to pay off the debt while covering operational expenses simultaneously.
Also, you may have to make additional changes for your desired investment to produce the intended result. For example, taking on more workers is only beneficial if you have the systems and processes to smooth out operations. Likewise, spending money to market yourself more aggressively is pointless if you haven’t developed an effective strategy.
2. Ask For the Right Amount
The risk of default is extremely slim if you ask for the right borrowing amount. Before figuring out your desired investment’s actual cost, you must first determine how much cash your business has on-hand for paying off debt. The answer to this question lies within a mathematical formula called the debt service coverage ratio, or “DSCR.”
Cash flow / Loan Payment = DSCR
The first part of the ratio can be your monthly or annual cash flow, while the second represents how much debt you’d hypothetically have to pay back on a monthly or yearly basis, depending on what you used for the first part. If your answer is above 1, you would easily be able to pay off this hypothetical loan while covering regular business expenses.
Next, consider the additional expenses you will incur after making your desired investment. For example, if you buy a bigger refrigerator for your restaurant, will you also have to buy more inventory to fill it? If your marketing campaign is supposed to bring in more leads, will you have to hire more salespeople to close them? Once you factor in these costs, you may conclude that you should ask for up to 50% more than your original investment cost.
3. Know the Cost of Debt for Business Loans
When shopping for business loans, it’s imperative to know each option’s actual cost. At first, that seems pretty straightforward: you just calculate the loan’s APR, right? This might help you determine the cheapest option available. But when you think of the big picture, it becomes clear that APR does not account for numerous other factors that affect the cost of the debt.
For example, many businesses take advantage of business loans primarily because they can deduct interest payments from their taxes. Then there’s the amount of revenue your business stands to generate from the loan. Both factors could dramatically lower the loan’s long-term cost.
Any experienced business owner knows not to accept external funding without eliminating any uncertainties regarding cost. You can do this by calculating the loan’s cost of debt. Applying this simple formula will confirm whether an option’s potential for income growth indeed surpasses its cost.
Business owners tend to get so wrapped up in statistics like interest rate, payment frequency, and payment size that they forget about the loan’s purpose. Understanding the cost of debt ultimately makes it easier to justify taking on the amount of debt that directly coincides with your business’s goals.
In this section, we’ll explain how to calculate the cost of debt, how it affects your options for business loans, and how to lower the cost of debt for your next loan.
What is the Cost of Debt?
By definition, the cost of debt refers to the total amount of interest the borrower pays over the loan’s full term. Unlike other formulas used to measure the cost of business loans, the cost of debt accounts for tax deductions on interest payments.
Business owners often calculate the cost of debt primarily to compare it to their projected income growth after receiving additional capital. Therefore, this number can determine if the amount of money you’d owe outweighs the loan’s financial benefits. Proving that an option will bring in more money than it costs can also reveal the loan’s capacity to increase profits.
For many business owners, choosing the right business loan means finding the lowest interest rate. The criteria for “low,” however, depends on the loan’s purpose. For example, one financial institution might offer the exact amount you asked for, but not at the interest rate you imagined. But then you remember that this amount of money will most likely triple your customer base. Despite its moderate interest rate, the loan’s benefits still outweigh its cost.
Financial institutions can also base their decisions on how the cost of debt compares to your projections. They might look at your business plan and conclude that the loan’s purpose does not have the potential to pay off the cost.
How Do You Calculate Cost of Debt?
Different financial professionals use different formulas to calculate the cost of debt. Here are the most common:
Cost of Debt = Interest Expense (1 – Tax Rate)
As you can see, the formula involves just two figures: interest expense and tax rate. The ambiguity of each figure makes this seemingly simple equation much more complicated. Different financial institutions present and advertise their interest expense in different ways. For example, one institution might quote an APR, while another might give you the total payback amount.
The tax rate also refers to your business’s average income tax rate, which must account for federal, state, and local taxes. You can’t just find this figure on last year’s tax returns, partially because your tax bracket may have changed following recent tax reform laws.
It’s your accountant’s job to know your average income tax rate. But if you want to figure it out for yourself, divide your total tax liability (how much you owe per year) by your overall taxable income.
“Interest expense” refers to the total interest cost of the loan throughout its full term. This includes all loan fees you can deduct on your taxes. Since most institutions don’t advertise their total interest expense, you’re going to have to ask for it. Theoretically, you should do this for every business loan on the table.
Now that you’ve got the formula’s two figures, you can go ahead and calculate the cost of debt. In the following section, we’ll show two examples of the formula in action. The second will account for another thing that can complicate the cost of debt: compounding or amortization.
Cost of Debt: Easy Example
The length of time it takes to calculate the cost of debt depends on how long it takes to produce the two required figures. In this example, a $90,000 loan has an interest rate of 12%. The business has an average tax rate of 20%. With no compounding or amortization to worry about, you can just use the advertised 12% interest rate.
Let’s apply those numbers to the cost of debt formula:
12% of 90,000 = 10,800
10,800 (1 – .20) = 10,800 x .8 = $8,640
This means that throughout the full term of the loan, the borrower will pay $8,640. You can’t call that number “high” or “low,” however, until you compare it to your projections for income growth. This will essentially tell you whether or not the loan offers an ROI.
In this example, let’s say the business plans to use the loan to make investments capable of generating at least $30,000 in revenue. That number far surpasses the cost of debt, which officially makes this loan an advantageous option.
If the borrowed funds only had the potential to generate closer to $10,000, on the other hand, you might want to look for alternatives. Sometimes, you have to calculate the cost of debt for several loans before you find one that offers the most affordable interest rate and terms.
Cost of Debt: Complex Example
Many business term loans have amortization schedules. This means that different portions of your payments will go towards the amount borrowed (the “principal”) and the interest over the loan term.
In most cases, the majority of your earliest payments will go towards interest. When you reach the middle or end of the term, most of the payment amount goes towards the principal.
Finding the cost of debt for this type of loan starts with the amortization schedule. This will show the interest expense of each payment. Adding up the interest expenses for each payment over one year will give you your “interest expense,” the first figure in the formula.
So, let’s say the borrower has five years to pay back the $80,000 loan mentioned above. The amortization schedule shows that after one year, the borrower will have paid $6,000 in interest.
Here’s how to calculate the cost of debt for this loan:
6,000 (1 – .20) = $4,800
Unsurprisingly, the longer terms make the cost of debt per year lower. However, the longer the amortization term, the higher the loan’s overall cost if you take the whole term of the loan to pay it back. To determine whether the loan’s potential for income growth surpasses its cost, estimate how much revenue it will generate in one year.
What About Fees?
Most business loans come with several fees. This can include loan origination fees, document preparation fees, processing fees, credit check fees, etc. You need to account for non-tax-deductible fees to ensure an accurate cost of debt.
Instead of adding them to your interest expense, just add them to the final calculation. But remember, this only applies to non-tax-deductible fees. You wouldn’t include deductible fees because you don’t actually have to pay them. Deciding which fees you can and cannot deduct can get complicated, so you’ll want to talk to your accountant before making any assumptions.
For example, while borrowers can usually deduct loan origination fees (or “application” fees), they cannot deduct packaging fees.
How To Lower Your Cost of Debt:
You shouldn’t begin shopping for business loans if you have any doubt that your business can sustain this much debt at this time. In other words, you must first determine whether or not you’re truly ready to take on additional debt. You can do this by seeing what kind of options you can qualify for and calculating their cost of debt.
But after doing some calculations, you might conclude that neither option yields an affordable answer. In this case, you should probably turn your focus to lowering your cost of debt. This doesn’t necessarily mean you have to stop your search.
Here’s how to decrease the cost of debt for your next business loan:
1. Lower Your Interest Rate
Nothing will decrease your cost of debt quicker than becoming eligible for lower interest rates. So, think of the many ways aspiring borrowers can gain access to the most affordable business loans.
Regardless of which institution you work with, credit score remains the top requirement for lower interest and longer terms. How can you raise your credit score? To start, you could reduce your credit utilization rate, pay off debts with the highest interest rates, and check your credit report for any errors. You can also gain access to more affordable options by putting up collateral. This could include business assets like expensive equipment or personal assets like your house or car.
Finally, ask your institution if it’s possible to eventually decrease your interest rate as long as you continue to make timely payments.
You might think that lowering your interest rate just two or three percentage points won’t save you much money. If so, test this theory with the cost of debt formula. You will discover that decreasing an interest rate from 17% to 14% could lead to massive savings, especially for loans with longer terms.
2. Take Out a Second Loan
The previous section mentioned asking your institution to lower your interest mid-way into your repayment process. Even if the institution says no, you should still make moves to raise your credit score, increase revenue, and improve cash flow. This could make you eligible for another, cheaper loan from the same institution or an entirely different one. Yes, plenty of institutions have no issue approving borrowers with existing loans.
You could use this second loan to pay off the first, and your monthly payments would decrease due to the lower rate and longer terms. However, keep in mind that each institution has its own requirements for approving borrowers with existing loans. In addition to increasing revenue and raising your credit score, you might have to improve profitability or reach an age-related milestone (2 years in business, etc.).
3. Increase Potential for Revenue Growth
We’ve repeatedly emphasized that your cost of debt only becomes “low” or “high” after comparing it to your projections for income growth. Hence, raising those projections effectively lowers your cost of debt.
For example, let’s say you plan on generating $20,000 with the borrowed funds. Well, what if you restructured your strategy so that it could generate closer to $30,000? This would allow you to accept business loans with higher interest rates. Options that you may have previously dismissed as too expensive would now become fairly reasonable.
This shouldn’t require you to use your loan for an entirely different purpose. Trying to think of another plan so late in the game would likely increase the risk of failure.
Instead, you should look to make some minor adjustments to your current plan. This could include raising your prices, adding new details to your advertisements, or even speaking to another supplier to decrease the cost of goods sold and increase profitability.
4. Look for Shorter Terms
Small business loans with shorter terms typically have higher interest rates. However, their cost of debt tends to run on the low side because you’d only have to make interest payments for less than one year.
Shorter terms can also lower your cost of debt when comparing business term loans of the same amount. For example, let’s say your research yields two $100,000 business term loans with dramatically different terms (5 years vs. 10 years) but relatively similar interest rates (15% vs
12%). The ten-year loan would have lower monthly payments. On the other hand, its cost of debt would likely surpass the five-year loan by at least $10,000. Since you have two similar interest rates, the massive discrepancy significantly impacts the ten-year loan’s cost of debt.
How Does APR Affect the Cost of Debt?
You’ve probably heard that unless you have poor credit or need funding right away, you should avoid short term business loans. These loans carry high APRs due to the increased risk on behalf of the institution. Therefore, over one year, you’d pay more interest than you would with an SBA Loan or any other option with longer terms.
But remember: APR only applies to that time frame: one year. The cost of debt, however, measures the total interest expense over the loan’s full term. With short-term loans, you might only have to make interest payments for three to four months. So, while an SBA Loan might cost you less over one year, the cost of its full term would far surpass what you’d pay with shorter terms.
Which Business Loans Have a Low Cost of Debt?
As you can see, business loans with the shortest terms tend to have the lowest costs of debt. Multiple types of business loans have short terms but very different repayment structures and borrowing limits. Below, you will find descriptions of these loans along with their typical interest rates:
Each institution has its definition of “short,” but most short-term business loans carry terms of four to eighteen months. The shortened terms eliminate the need for interest payments, but this can also vary from institution to institution. You can borrow as little as $1,000 and up to $250,000. Interest rates start at 10%, though the maximum APR can reportedly exceed 25%.
Business Line of Credit
After approval, you can borrow from your business line of credit at any time. You only pay interest on borrowed funds, so your rate depends on how long it takes you to pay off the amount you owe. In the case of revolving lines of credit, you can keep borrowing as long as you continue to pay back the total amount you just borrowed.
Once you pay off the total balance, the credit line replenishes. You can borrow $1,000 up to $1 million, with terms ranging from six months to five years. Interest rates typically start at 7% but can range as high as 99%.
Working Capital Loan
Similar terms and interest as short term business loans, but the borrowing amount stems directly from the monthly costs of running your business. You can borrow $10,000 to $5 million, with interest rates starting at 9%.
If you have an unpaid invoice, you can sell it to an institution for approximately 85-90% of the original value with accounts receivable factoring. The institution pays you this money right away and takes responsibility for collecting from your customer.
When the customer pays the institution, you will receive the remainder of the original value, minus another percentage. Instead of interest payments, the institution deducts percentages known as “factor rates.” They typically start at around 5%.
Not Sure About That Loan? Calculate Cost of Debt
For many business leaders, an appropriately-priced business loan simply means reasonable monthly payments and APR. While both metrics can provide valuable insight into the loan’s cost, they cannot confirm whether the loan makes sense from an investment perspective. That’s where the cost of debt comes in. If anything, it simply helps borrowers remember why they applied in the first place: to grow their income and make the repayment process as seamless as possible.
When Does it Make Sense to Pay Off a Business Loan Early?
The decision to pay off a business loan before the scheduled due date is not as clear-cut as you’d think. Possible risks include prepayment penalties and damage to your credit score. You might not even be permitted to pay off the loan early.
So, before taking this route, you must first make sure paying early is the best course of action available at this time. Here are a few things to consider when making this decision:
1. What are the Terms of Your Loan?
Reread the fine print. Some business loan terms state that any early payment must be made within the first 90-days of the loan.
2. Are There Prepayment Penalties?
Business lenders charge prepayment penalties because paying early deprives them of interest payments. In other words, they make less money on the loan than they originally intended. Check if your loan has prepayment penalties before you even think about paying it off early. Some business lenders do not charge prepayment penalties at all. If there’s a decent chance you’ll be able to pay off your loan early, ask about prepayment penalties when deciding which business lender to work with.
3. Will I Save Money by Paying Early?
If you can pay off the loan early without incurring any additional fees, interest, or penalties, paying early may be a wise decision. However, in some cases, continuing to make payments would allow you to save more money over time than just paying the full principle now. If you’re not sure, ask your business lender.
4. Will Paying Early Affect Business Credit?
The number one factor in your personal and business credit score is your record of timely payments. Paying early shortens your payment record and gives you less room to improve your credit. Hence, if you’re looking to boost your credit score, paying early significantly might not be the way to go.
5. Will I Have Trouble Obtaining Additional Loans?
Though your business lender might not charge prepayment penalties, paying early might make it harder to obtain additional loans from this same source in the future. Think about it. You’ve already deprived them of interest payments once. If the business lender gives you another loan, you might just do the same thing again. Would the business lender want to take this risk?
6. Are There Alternatives to Paying Early?
You may want to pay off your business loan early to avoid more monthly payments. But if you believe your payments are excessively high, your business lender may be willing to lower them. This would allow you to save more money each month. You may also take out a second loan with a lower interest rate to pay off this first loan. Believe it or not, that might be cheaper than paying early. And you wouldn’t lose the opportunity to keep improving your credit score.
7. Will Paying Early Affect Tax Deductions?
Interest payments and prepayment fees on business loans are usually tax-deductible. But once you pay off the loan in full, the deduction no longer applies. To clarify, the deduction is based on the amount of interest in your payments. For this reason, paying early may result in a lower deduction.
8. How Much Would I Actually Have to Pay?
Before assuming that early payment is the best route, you must first make sure you know how much is due. All of the information you need to figure this out can be found on your loan agreement:
- Percentage of remaining loan balance – This can be anywhere from 10 to as much as 40 percent. Do the math. If you have a 20 percent prepayment fee and currently owe $23,000 on the small business loan, then you can expect to pay a $4,600 fee on top of your loan balance, to the tune of $27,600.
- Lump-sum, 90-day option, to pay early – If you exercise an early payoff in the first 90-days of a short term business loan, you may be assessed a fee for this option. The fee is generally attributed to a portion of the loan interest. Ask your lender for a copy of your amortization schedule, which shows what you’ve paid and what you owe, along with any additional fees.
- Short term loan penalties and other fees to watch for – While not as common, some small business loans include short term penalties and other fees, which may be calculated on a sliding fee scale. Longer loans with fixed-rates are most prone to see this type of penalty so that you may be in the clear with a short-term loan.
What Should You Do If You Can’t Pay Off a Business Loan On Time?
We’ve repeatedly alluded to the inevitability of unforeseen expenses. Well, sometimes, these expenses can prevent you from paying off your business loan on time. Thankfully, there are several solutions you can try before resorting to extreme measures:
1. Contact Your Finance Company Immediately
If you aren’t sure you’ll be able to cover your future monthly payment, don’t wait until it’s due and hope for the best. Instead, pick up the phone and explain your dilemma to your business lender. Remember, defaulting hurts both parties. Your business lender does not want you to default and therefore has a set procedure for avoiding this outcome. They may be able to extend your loan or lower your monthly payment.
2. Make Internal Changes
There may be changes you can make to help meet your monthly payment obligations. For instance, maybe you can cut your marketing spend since it hasn’t brought in as much revenue as expected. You can also enact strategies to increase the amount of cash that flows into your business each month. Examples include offering new invoice terms or following up with clients who usually pay late. If you are looking for new clients, ask for a deposit upfront. Another potential solution is enlisting tools that might allow you to make more sales, like automated email systems.
3. Take Out Another Loan
Taking out a business loan to repay another loan requires additional precautions. First, you must confirm that you’ve done everything in your power to lighten your monthly obligations (i.e., the solutions recommended in the previous section). Then, explain the purpose of the desired loan to the potential lender. If the lender has experience in this situation, they will give you a loan that allows you to pay off the first loan and fix the cash flow problem that got you into this misfortune in the first place. The business lender might also provide some direction as to how to use the funds. For example, instead of just using the funds to pay off the first loan, it might be better to distribute it across all of your debts.
4. Get Others to Support Your Financial Goals
Reach out to your vendors, suppliers, and credit card providers to negotiate lower rates or longer terms. You may be able to reduce your monthly payment or receive a discount on inventory in the near future. Also, educate your employees about ramping up sales and being more mindful of business resources. Odds are, your employees will have their suggestions for how you can cut expenses and make better use of your time.
What is Equity Financing?
Many new businesses cannot afford to cover startup costs and recurring expenses with their own money. Of course, this doesn’t mean the company has no shot of opening. The owner just needs to find another source of funding. In most cases, the search for financing ends with one of two solutions: debt financing or equity financing.
Debt financing refers to the use of business loans, which can come from banks, online lenders, or peer-to-peer lenders. The business must then pay back the lump sum, plus interest and fees, by the agreed-upon due date. Aside from your obligation to pay off the debt, nothing else changes regarding the way you run your business.
Equity financing, however, has completely different rules. If certain disadvantages of debt financing seem too restrictive, equity financing may give you more power to grow your business without damaging cash flow.
In this section, we’ll define the various forms of equity financing and help you figure out which financing option makes the most sense for your goals.
Equity Financing: Expanded Definition
Equity financing allows businesses to obtain funding in exchange for shares of the company or pieces of ownership. Selling shares eliminates the need to pay back the source of the funds. But despite the lack of interest and fees, the business owner relinquishes full control of the business.
The shares you sell represent units of ownership. For example, let’s say your business has 1,000 shares of stock to issue. If you keep 500 shares and sell the other 500 to an investor, that individual now owns 50% of your business or has 50% “equity.” So, even though you probably came up with the idea for the company and will manage the employees on your own, the investor technically has just as much power as you.
The amount of shares you sell usually corresponds to the amount of capital the investor gives you. An investor with 50% equity would have probably covered half (or more) of your startup costs. Once an investor distributes funding and receives ownership shares, the title changes from investor to “shareholder.”
What Do Investors Get Out of Equity Financing?
Investors who buy equity in startups usually receive shares of “common stock.” Owners of common stock earn their ROI (return on investment) through dividends or portions of the company’s profits. They also get voting rights at board meetings to voice their opinions during decisions about policy, management structure, etc. Depending on the amount of money invested, individual common stock shareholders may have the right to multiple votes. In other words, the single vote of one common stock shareholder could essentially have the power of three votes.
Companies choose to issue different types of common stock: A-Class and B-Class. There’s no all-encompassing definition for either term. The availability of A-Class and B-Class stock merely denotes that a kind of shareholder (A-Class) gets more advantages than the other (B-Class). For example, while an A-Class shareholder might get three votes, B-Class shareholders might get just one vote or lower dividends.
Though most companies issue only common stock to investors, the company can choose to issue preferred stock. Preferred shareholders have no voting rights, but they do have dividends along with higher claims on the business’s assets than common stock shareholders. Should those assets get liquidated, the preferred shareholders would make more money.
All types of shareholders, however, have the right to sell their shares. Shareholders typically do this after the business has achieved considerable success, which increases the share’s value. Despite the higher price, the business’s upward trajectory may still attract buyers.
As you can see, businesses can customize the stock they issue based on the type of investor they wish to bring onboard. But what kind of investors will you have to choose from, anyway? We’ll answer that in the next section:
The Different Kind of Investors in Equity Financing:
Investors who buy equity in businesses usually fall into two categories: angel investors or venture capitalists.
Here’s what you need to know about each type:
The “angel” in angel investors comes from the trust these investors put in the business owner, even though they have little (if any) data to support their decision. It’s as if they have answered the entrepreneur’s desperate plea for an “angel” to believe in their dream and make it come true.
Angel investors (a.k.a. seed investors or private investors) typically use personal funds to bestow large amounts of working capital to new businesses in exchange for equity. They can distribute their entire investment at once or in portions as the business grows.
Since angel investors specialize in getting new businesses off the ground, they often understand that they need a lot more than just money.
What Motivates Angel Investors?
Every angel investor has his or her reasons for helping new businesses succeed. Most, however, find their motivation from one or more of the following rewards:
1. Early Investment = High ROI
By definition, all equity financiers seek high ROIs. Angel investors have an especially good chance of achieving this goal because they make their investments during the business’s infancy. It’s just like the stock market: The most significant rewards often go to investors who take the risk of buying stocks in companies that no one has heard of but eventually become massively successful. For this reason, the interest of an angel investor gives new businesses tremendous confidence.
2. Another Opportunity to Lead
Many angel investors are retired entrepreneurs looking to take on another leadership role. Maybe they love the challenge of business growth and want to test their skills in today’s climate. Perhaps they want to bestow their wealth of knowledge onto someone else with a great business idea. All entrepreneurs make mistakes. Becoming an angel investor allows them to put their experience to use by showing another entrepreneur how to avoid common missteps.
3. Compassion for Underdogs
Some angel investors specifically pursue entrepreneurs who have the odds stacked against them. This includes female entrepreneurs, minority entrepreneurs, or even businesses located in up and coming areas. These angel investors may seek to increase diversity within specific industries or simply bring the gift of entrepreneurship to more groups of people.
How Do You Find Angel Investors?
When it comes to the most critical skills for entrepreneurs, networking sits right at the top. Superb networking skills make it much easier to obtain clients, partners, employees, and, yes, equity financiers. There’s no angel investor database to go to for funding. Instead, you must tap into your networking skills and find angel investors through certain people or events. You could talk to other entrepreneurs, financial advisors, investors, or simply anyone connected to wealthy social circles.
Venture Capital Firms
Venture capital firms have the same essential function as angel investors: funding early-stage businesses in exchange for equity.
But unlike angel investors, the money doesn’t come from one person. When you obtain funding from venture capitalists (“VCs”), the entire firm becomes your partner. So, instead of selling equity to one person, you sell it to another company.
And while angel investors show their namesake by putting faith in your ideas, venture capital firms tend to base their decisions on data. It’s all about the money for these firms, so they often need more hard evidence to support their investments.
Venture capital firms distribute funding in three rounds. The first round, or “Series A,” gets distributed during the company’s infancy, with Series B and Series C getting distributed as the company grows. Each round of funding comes with another exchange of equity.
How are Angel Investors Different From Venture Capital Firms?
Every venture capital firm and angel investor has their policies and procedures. But for the most part, here are a few areas in which you can expect significant differences between the two:
1. Venture Capitalists Usually Make Larger Investments
Compared to angel investors, venture capital firms usually have the means to offer much more money. But remember: more funding for your company means more equity for the firm. Though each firm has its own minimum investment, you probably shouldn’t pursue venture capital unless you’re looking for at least $1 million. The size of the typical VC investment reflects its number one priority: explosive growth.
2. Venture Capitalists Expect More Power
Most angel investors allow entrepreneurs to manage their businesses on their own. Many VC firms, on the other hand, will only work with entrepreneurs willing to give up some degree of authority. This could range from providing suggestions here and there to creating an entire plan that the business must follow to receive more funding rounds.
3. Venture Capitalists Have Bigger Goals
Earlier, we mentioned that venture capitalists set their sights exclusively on companies with massive success potential. VC firms don’t just want to help your company make money. They often strive to turn tiny startups into publicly traded companies. After distributing the final round of funding (Series C), VC firms sometimes move straight to an IPO, resulting in incredible earnings for early-stage VCs.
4. Venture Capitalists Work with Limited Industries
Since VCs only work with companies with high growth potential, they tend to favor industries with high growth potential. VCs also won’t work with industries they’ve never worked with before.
This differs tremendously from angel investors, who base their decisions primarily on the entrepreneur’s intelligence and character. As long as the angel investor believes in the entrepreneur’s idea, they might not care about factors like industry, data, or prior experience.
5. Venture Capitalists Need More Data
Acquiring funding from VC firms involves much more effort than impressing an angel investor. The latter option might only need an elevator pitch or general business plan before agreeing to provide seed capital. In terms of documentation, VC firms will expect to see much more, like your going-to-market strategy or proof of market traction. Your business plan should show the firm that you know how to approach the different growth stages and will only spend their money on growth-related initiatives.
In summary, most venture capital firms and angel investors have different objectives. While angel investors find satisfaction in turning nothing into something, venture capital firms only succeed when they turn small businesses into international sensations.
How Do You Find Venture Capital Firms to Work With?
Anyone with money can become an angel investor, so there’s no real limit on the angel investor marketplace.
Believe it or not, the number of established venture capital firms in the entire world reportedly does not exceed 300. And only some of those firms will want to work with businesses like yours. You should still start your search for venture capital firms in the most logical place: The National Venture Capital Association. This will show you how many firms specialize in your industry and which firms have distributed the most funding as of late.
Remember: Venture capital firms heavily favor businesses that seem fully prepared to grow. So, don’t contact any firms unless you’ve taken every necessary step in this direction, aside from seeking funding.
What Are the Pros and Cons of Equity Financing?
At this point, you should have an idea of what it’s like to work with angel investors and venture capitalists. Now that you know what each option has in common, we can deduce the advantages and disadvantages of equity financing in general. Let’s recap why one business would choose equity financing and why another might seek another source of funding:
Pro: No Repayment Required
Debt financing involves owing money and paying it back by an agreed-upon due date, plus interest and fees. If you choose the most traditional type of loan, you’ll have to make fixed, monthly payments immediately after receiving funding. Short or medium-term loans might have shorter payment frequencies (daily, weekly, bi-weekly, etc.). Missed payments can result in penalties and hurt your personal credit score. It’s also hard to make fixed payments when revenue fluctuates due to uncontrollable factors like seasonality.
With equity financing, on the other hand, you don’t owe any money. Even if your business fails, your angel investor or venture capital firm cannot legally demand money from you. They knew about this risk before making their investment. When you take out a business loan, it’s the borrower who assumes the most risk.
Small businesses repay debt without damaging their cash flow all the time. But it’s easy for growing companies to borrow more than they can afford to pay back, especially without a stable foundation for revenue.
Con: You’ll Earn Less Income
Choosing equity financing means sacrificing total ownership of your business. You must now split the profits with your angel investor or venture capital firm. Until your business becomes massively successful, you might have to put specific personal plans on hold.
Some entrepreneurs make the mistake of continuously taking on more equity financing without realizing its effect on their ownership of the business. Multiple funding rounds might sound great, but each one takes away more and more of the original owner’s profits.
Forfeiting future profits could also prevent you from receiving your hard work’s full reward, especially if you plan to sell your business. Let’s say you eventually sell your business for $110 million. If you had previously given away just 10% of your ownership, $11 million could go to someone who (possibly) had no strategic impact on your success.
You wouldn’t lose anywhere near as much, however, if you borrowed a few million to finance your startup and paid it back over several years.
Pro: You’ll Receive Valuable Business Advice
Though anyone can become an angel investor, most equity financiers have significant experience with business growth. Their wisdom becomes yours when you make them equity financiers with voting rights. Offering potential buyers the rights to multiple votes shows that you value their advice and intend to comply with their ideas. When faced with tough decisions or unforeseen curveballs, it’s often experience that ultimately guides the business in the right direction.
You might assume that any smart business owner should know how to make these decisions on their own. But most business owners do not excel at every element of their jobs. Someone who comes up with great ideas for new products, for example, might not know how to correctly market those products or decrease the cost of goods sold.
The guidance of your equity financier could prove especially critical if you’ve never managed this much money before. Distributing such a massive budget to an inexperienced entrepreneur could result in careless or rushed spending.
Debt financing tends to have the opposite effect: It teaches new business owners to spend carefully and efficiently. If you spend the money on the wrong investment or fail to generate enough revenue, you won’t be able to pay it back. Many successful business owners benefited from learning how to manage debt early in their careers.
Con: They’ll Have Control of Your Business
Of course, selling equity also runs of the risk putting substantial power into the hands of someone you might not always agree with. Your equity financier might have completely different goals but keep them hidden until coming on board. And since this person or firm is essentially keeping your business alive, it’s not as if you’re in the position to say no.
Some equity financiers might just want to make as much money as possible in the quickest time frame. Others might dismiss personal relationships with employees if letting them go makes more financial sense. For example, your equity financier could ask you to replace an employee who helped you start your business for someone else who could do the same job for half the salary.
To avoid this all-too-common situation, research your potential buyer’s previous ventures before selling your shares. You may even want to speak to their former partners about their management style and preferred degree of influence.
This segues into arguably the most significant advantage of debt financing. If you work with an online lender, you don’t even have to explain how you plan to use the money to be approved for a business loan. As long as you continue to make payments, you can run your business in any way you please. And once you make your final loan payment, your partnership with the financial institution ends.
Is Equity Financing Right for You?
Yes, equity financing lacks some of the most significant disadvantages of debt financing. But the former option will undoubtedly have a much more significant impact on your business, as well as your future as an owner. When you accept a substantial investment, the entire trajectory of your business could change. From that moment forward, you absorb the additional responsibility of keeping your angel investor or VC firm satisfied, partially to ensure access to further rounds of funding later on.
While debt financing can’t offer you the same amount of money as equity financing, certain institutions specialize in long-term partnerships. Clients can continuously take out large-sized business loans with increasingly favorable terms. These institutions can also provide expert advice associated with equity financiers. To recommend the right products and the most reasonable terms, they find their clients’ financial problems’ underlying sources. This allows the institution to develop effective solutions instead of a temporary fix.
Before deciding which type of financing is right for you, be sure to consider the magnitude of equity financing, and remember that not all financial institutions are the same.
Business Debt: Not As Scary As It Seems
The ability to manage debt will get you very far in life, personally and professionally. It’s very similar to the skill set required to spot a wise investment or make the most out of limited resources. If you can manage a safe amount of debt while growing your business, you’ll be able to identify potential cash flow issues well before they spiral out of control. After all, taking on the right amount of debt means taking on the right amount of risk. Too much is dangerous, but just enough is essential for success.