Debt financing for startups involves receiving borrowed capital. When a startup borrows money from outside sources at an interest rate, this is referred to as debt financing. There are several ways to raise capital, including debt, equity, or a combination of the two. Thus, debt financing and equity financing are important sources of funding for any business.

What are various Sources of Debt Financing?

There are numerous debt financing instruments available in the market sources. Some of the most prominent are listed below:

Bank loan/Business loan:

Banks and other financial organizations offer business loans with or without collateral security. Banks frequently evaluate each company’s unique financial status and adjust loan amounts and interest rates accordingly.

Loans can be taken out for short-term or long-term goals, depending on the needs of the business, such as the need for working capital, the acquisition of capital assets, business expansion, etc.

Trade Credit

This type of agreement allows businesses to pay for products they buy now with interest. This is hence financing for short-term debt. Furthermore, collateral security is not needed. This makes it most practical for startups and small enterprises.

Installment Purchase

This is another effective method of financing debt. In this case, the buyer mortgages the assets it wishes to buy and pays in predetermined amounts over time. This is appropriate for businesses with better market credit ratings. They don’t need to mortgage any more assets in order to buy assets from banks and financing businesses.

Asset Based Lenders

These lenders are financing companies that give businesses money to buy assets based on the mortgage of the company’s assets, such as stock, debtors, etc. As a result, it is highly helpful for businesses that have a lot of debt, inventory, etc.

Bonds

The people or organizations who buy the bond subsequently lend money to the company, making them creditors. A conventional bond certificate has an interest rate, a principal amount, and a deadline for repayment.

Factoring

Factoring is a service provided by certain banks. Here, a company doesn’t have to wait for customers to pay them; instead, it receives money up front from a banker based on invoices sent to clients. The banker charges a commission for this service.

Insurance Companies

A significant source of funding for small businesses is provided by insurance firms. They offer mortgage loans and policy loans, two different kinds of loans, to businesses. Any of the company’s assets may be mortgaged in order to obtain a mortgage loan.

Inter-corporate Loans 

For financial needs, a business may borrow money from another business. It must abide by the terms of the Companies Act while taking out such a loan.

Advantages of Debt Financing 

• When it comes to funding, debt is less expensive than equity financing.
• It benefits tax-wise because interest paid on debt is deductible as an operating expense while dividends paid to shareholders are not.
• The primary motivation behind corporations opting for debt financing over equity financing is to maintain corporate ownership.
• Because debt holders have a priority claim on the company’s assets while equity holders do not, debt holders are more protected in the event of collapse than equity holders.
• Debt is less expensive than equity because it carries less risk. Debt holders do not receive the same returns that equity investors do.

Disadvantages of Debt Financing

• At first, debt might be a favorable alternative, but as the business is overleveraged, taking on more debt becomes more expensive.
• A company’s credit scores also drop when it has greater debt.
• They must guarantee that the company makes enough money to cover principal and interest payments on a regular basis.
• Even if the company fails, the loan still needs to be paid back. When they provide collateral to a lender, their personal assets and occasionally even their company assets are at stake. Above all, they run the risk of going bankrupt.
• When it comes to debt finance, the borrower bears more risk than the lender. Interest and principle must be repaid even in the event that the business makes no money.

One excellent source of funding is debt financing. It meets both immediate and long-term needs. One benefit of debt financing is that ownership does not have to be shared with anyone. As a result, the promoters continue to have total control over the situation without external intervention.