Ten Types of Debt Financing That You Should Know

Nothing’s free in this world, and that includes things that you need to run your business.  Yes, some people start and run businesses without ever taking out any kind of debt financing, but that kind of bootstrapping is as rare as it is difficult.  To completely bootstrap a business, you’ll need to cover startup costs yourself and then cover 100% of your ongoing expenses out of your cash flow when those expenses arise (as opposed to when your cash flow shows up).

Well, gosh, isn’t that the definition of a profitable business, you might ask?  Well, only in the long run.  Even if your cash flow is more than sufficient to cover your expenses over a time horizon of a few years, you might notice that your expenses and your cash flow don’t always show up at the same.  For example, you might have to go purchase inventory and pay for it either right then and there or within, say, thirty days thereafter, and then that inventory might sit on your shelves for a few weeks before a customer buys it, and you aren’t getting paid until he does.  In this example, you have to pay an expense several weeks to a couple of months before you’ll generate the cash to pay the expense.

That cash crunch is actually one of the most common reasons why small businesses fail.  Cash is king, and the most important thing is to keep the cash coming in the door so that you can keep paying your expenses, keep selling, keep getting paid, keep rinsing, and keep repeating.  Businesses that run out of cash, even for short periods of time, don’t stay in business for very long.  They fall behind on paying suppliers and employees, who ultimately leave, and they can’t always acquire the products that customers want to pay, so they leave, too.

We’ll have more to say in a future post about how to decide whether your business needs debt financing and which type of debt financing is right for you, but for now, here’s a quick overview of ten types of debt financing that you might come across.

1. Term Loans

A term loan is what you probably think of when you think of a loan.  A lender lends you a fixed sum of money for a fixed period of time for a fixed interest rate, and you pay the loan back over time until the balance is gone.

And in general, that’s exactly what it is, but the devil’s in the details.  In fact, there are all kinds of variations on this general pattern, leading to a large variety of term loans.  For example, you might actually have a variable interest rate that changes based on the prevailing interest rate, sometimes called the prime rate.  You might be able to pay only interest for a certain period of time instead of having to pay both interest and principal as amortized over the life of the loan.  Or you might have a large balloon payment at the end of the term of the loan.

Term loans are sometimes called bank loans or bank debt when the lender is–surprise, surprise–a bank.  You’ll frequently see term loans when someone wants to acquire a business and needs to take out a loan to finance the purchase.  You might also see a term loan referred to as an SBA loan when the U.S. Small Business Administration is guaranteeing the loan.

2. Lines of Credit and Revolving Loans

A line of credit is like a term loan but with an added twist.  With a line of credit, a lender makes available to you a certain amount of loan proceeds, and you can draw on it whenever you want.  And you might decide that you don’t need to draw on any of it right away.  And that’s allowed.  Unlike with a term loan, when a lender would disburse all of the loan proceeds to you up front, with a line of credit, you have discretion to take the money when you need it, and then you’ll pay it back over time.  As with a term loan, though, the amount of a line of credit is a fixed amount, and once you’ve borrowed that amount, you won’t be able to borrow any more on that line of credit.

A revolving loan is like a line of credit but with an added twist.  (Is there an echo in here?  It’s almost like we chose to discuss these forms of financing in this order on purpose…)  With a revolving loan, just like with a line of credit, you can draw down on the loan proceeds whenever you want, but unlike with a line of credit, once you hit your limit, you can pay off all or a portion of the balance, and then you can re-borrow the amount that you paid off.

3. Credit Cards

Credit cards are probably the most familiar form of debt financing because even if you don’t have a house with a mortgage, you very likely do have a credit card.  Businesses can take out credit cards just like individuals can, and there are a lot of good reasons to do so.  But just like how individuals can get into trouble with credit card debt, businesses can get into trouble with credit card debt, too.  That tends to happen when we treat credit cards like term loans that we pay off over long periods of time because interest rates on credit cards tend to be very high.  So be careful using them and try to treat your business credit card like a revolving loan that you may off in full every month to avoid high interest charges.

4. Inventory Financing

Inventory financing allows you to borrow money to finance the purchase of the inventory that you plan to sell.  It’s a form of asset-based financing because the amount that you can borrow depends on the value of the assets, in this case inventory, that you hold, not your credit rating or the amount of income you have.  For this reason, if you don’t repay the loan, then the lender could seize your inventory.  (Banks tend not to want to do that because they aren’t in the business of selling inventory, and that can sometimes mean that they won’t lend you the full amount of the inventory and may charge high interest rates.)

5. Purchase Order Financing

Purchase order financing is one of the more obscure forms of financing and one of the less intuitive ones.  It can be useful when you receive an order from a customer and need to have your supplier provide the product.  When you receive an order, you let your supplier know and then get purchase order financing from a lender.  The lender will pay your supplier, and the supplier will ship the goods directly to your customer (not you).  You will then send the customer an invoice, and the customer will pay the lender, and the lender will then send you your share. 

6. Accounts Receivable Factoring

Now let’s say that you’ve already delivered your product to your customer, and they owe you some money.  And so do a lot of other customers, as long as we’re on the subject…  When you have a large balance sitting in your accounts receivable for a long time, accounts receivable factoring comes into play.  You can sell those outstanding balances to a factoring company at a discount, and then the factoring company will collect the balance.  This discount operates a lot like interest.

7. Equipment Financing

Like inventory financing, equipment financing is also a form of asset-based lending.  It’s a loan that you take out in order to purchase the equipment that you need to run your business.  As you might expect, it’s generally secured by a lien on the equipment itself, so if you don’t pay off the loan, then the lender could seize your equipment.

8. Leasing

It might surprise you to see leasing listed under financing arrangements, but that’s precisely what leasing is.  You could take out a loan to buy a company car, or you could lease it.  In the first situation, your lender advances you the purchase price of the asset, you buy the asset, and then you repay the lender over time.   With a lease, the lessor continues to own the asset, and you pay for the use of the asset.  Either way, you get to use the asset, and if you stop paying, then you lose the asset.  But who owns the asset at any given point in time depends on whether you buy with a loan or lease.

The legal and accounting rules here aren’t just formalities; it can really matter who owns an asset.  For example, you might lease all of your office equipment, and if you later take out a loan secured by all of your business’s assets, then your office equipment won’t be included.  And historically, accounting rules treated leases differently than debt, so the related assets and liabilities wouldn’t show up on your balance sheet, which is why leases were sometimes referred to as a form of off-balance sheet financing.  (Those rules have been changing in recent years, by the way, so check with your accountant if you have any questions about them.)

One area to be careful with here is any covenants in any loan agreements you’ve signed.  They may require you to stay within certain ranges for various accounting ratios, and you’ll want to make sure that you discuss those obligations with your lawyer and your accountant so that you don’t inadvertently breach an agreement.

9. Merchant Cash Advance

A merchant cash advance is a loan is a little bit like accounts receivable factoring except that instead of selling the balances in your accounts receivable, you’re giving up a percentage of your daily credit card sales.  Your lender will look at your historical sales and then agree to lend you a fixed amount based on the percentage of daily credit card sales that you agree to sell to the lender.  The nice thing about a merchant cash advance is that you only have to pay out of your daily credit card sales, and when your business slows down, your payments will go down.  But don’t get too comfortable with that arrangement.  When you compare the amount of cash that you get for the percentage sales that you give up and figure out an effective interest rate, you could be paying a very high interest rate for this loan.  That’s why a lot of businesses consider merchant cash advances as pretty nearly a last resort when other forms of financing aren’t available. 

10. Personal Loans

Last but certainly not least is the financing option that everyone would like to stay away from but many ultimately have to consider to keep a business afloat, and that’s the personal loan.  You might be in a situation in which a bank just won’t make a loan to your business but you just need to get cash into the business however you can.  One way to do this is by taking out a loan in your personal name, potentially secured by your own personal assets, and then putting the cash into your business.  The obvious downside here is that if your business can’t repay the loan, then you can’t repay the loan, and then the lender can come after you personally.

And on that cheery note, regardless of which type of financing you’re deal with, make sure that you’ve fully thought through whether you really need to get outside financing, that you get the type of financing that’s best suited to you, your business, and your particular situation, and that you fully understand all of your rights and obligations under the legal agreements you sign.  It never hurts to talk to your accountant about your financing needs, and, since we can’t give you legal advice, always consider talking to your lawyer when you want to make sure that you understand a legal agreement.