Debt finance generally comes from institutions like banks and finance companies.
Debt financing pros
It's easier to find.
You retain full control of the business.
You keep profits to yourself.
Interest is simple to budget for.
Debt financing cons
It’s hard to fund innovative business ideas through debt financing. Banks prefer safe bets. If you have a mind-blowing new idea, you’ll probably need to explore equity financing, private loans, or presales.
Equity finance comes from investors and will require you to have good interpersonal skills.
Equity financing pros
You pay back nothing if the business fails.
You can access the investor's networks.
Investors give strategic advice.
Investors are open to risky ideas.
Equity financing cons
Investors get some control over your business and profits have to be shared. As a startup, you’ll sell shares at their cheapest. After a period of success, it may feel as though you gave them away.
Common types of bank loans
Banks offer debt financing in two main ways:
Where you borrow a lump sum for an agreed amount of time and make monthly repayments. The lender works out the interest you owe every month and adds it to your debt.
Line of credit
You’re given a borrowing limit and only withdraw the money if and when you need it. You only pay interest on what you use.
The amount of money you can get, and the interest rate, may depend on how you secure the loan.
How will you secure your loan?
Collateral is something that your lender can claim to get their money back if you stop making repayments. It can include things like:
real estate such as a house
other assets such as vehicles or expensive equipment
a personal guarantee, which allows the lender to sue you for unpaid loans
As you move down the list, the size of loans get smaller and the interest rates get higher. But to offer something as collateral, you have to be prepared to lose it, so this is often a difficult choice.
You can also take unsecured loans. A credit card is an example of that. But the borrowing limits will generally be lower and the interest higher.
How to apply for a loan
To apply for a startup business loan from a lender such as a bank, you will need these four things:
A good credit score
This shows how reliable you are at paying bills. (Learn more about credit scores.)
A solid business plan
Lenders will be interested to see your sales forecasts, budget, and time to profitability.
A shopping list
Say what the loan will be used for (including the cost of each item).
Collateral for the bank
You’ll also need to say what the lender can take if you stop making repayments.
How much to borrow to start a business
Your budget can help you here. It’ll show how much cash you need to build the business, and you’ll know how much of that needs to be borrowed. Now take that amount and work out what the monthly repayments will be. Most lenders have online calculators to help you. The bigger those repayments, the more sales you need to break even, so don't take this step lightly. Work with an accountant to see what you can realistically afford.
Operational costs are part of business finance
There are costs to start a business, and then there are costs to run it. You’ll need to have enough money in the bank to cover those first weeks or months of operation. There’s not much income in those early stages.
When taking a loan, consider taking out enough to cover early operational costs as well. Or, at the very least, make sure you still have enough credit left with the bank to go back to them later.
How to budget for debt
You don’t need to be afraid of debt. Most businesses live with it every day. But stay alert to the effects of interest charges. Work out what interest will add up to every year and put it into your budget as a cost.
Before you take a loan, check out what would happen to your budget if interest rates jumped up a couple of percentage points. How much more would it cost you every year? Could you still afford the repayments?
Alternatives to banks
Wondering how to start a business without a bank loan? We’ve already talked about equity (getting investors), but there are other options, too. Three of the more common are friends-and-family loans, peer-to-peer lending, and crowdfunding.
Friends and family loans
A lot of businesses start out with loans from family or friends. These are often agreed on a handshake, with no security put up by the borrower. However, it’s a good idea to write down the details of the loan and have both people sign it so there aren’t any misunderstandings.
The document should say:
how much has been borrowed
what it’s for (be specific)
the interest rate, if any
when interest will be calculated (monthly, quarterly, or annually)
when repayments will be due (monthly, quarterly, annually)
when the loan should be repaid in full
Some websites introduce people who have spare cash to people who need it. You can send in a pitch saying how much money you need and why. If they agree to post it to their site, someone could back you. People who lend money through these sites are generally taking bigger risks than banks, and so they expect higher returns. As a result, the interest rates can climb. But that’s not always the case if you have a solid proposal. As a bonus, you don’t typically have to offer collateral.
Crowdfunding a business
Crowdfunding is a legitimate way to raise money. It can get you access to all types of business finance, such as:
You pitch your idea and offer shares in the business.
You pitch your idea and ask for pre-orders. You’ll need to declare how many orders are required for you to launch the business and, if you pass that amount, you’re expected to follow through.
Much like peer-to-peer lending, you can use crowdfunding sites to pitch an idea and ask the community to loan you the startup money.
Crowdfunding is like a popularity contest. You need to work hard to get noticed. Don’t just post your pitch and hope for it to catch fire. You’ll need a marketing and networking plan.
"Business owners are often not great at the numbers. Always have a list of financial goals before you even think about going into business if you want to be a success. Take it seriously to avoid being another statistic."
Lisa Martin, Go Fi8ure, Xero gold partner
Chapter 5: Budgeting and forecasting
Find out what goes into a budget, and how to pull one together. Learning these basics will better your chances of getting finance, and turning a profit.Read chapter 5