Different Types of Debt Financing

When incorporating, one of the major decisions you will be making is related to how you will finance your business venture. You have two major options: debt financing and equity ownership. The latter is easy to understand; the value of the business entity is calculated and investors are invited to take equity stakes in order to execute the business plan. With debt financing, you have various options, and you should evaluate all of them before making a move.

Types Of Debt Financing

Debt financing means taking out loans on behalf of the business entity. Unlike going to the bank to ask for a personal loan or apply for a credit card, the determination of creditworthiness will be made based on the company itself. That means that revenue potential and ability to repay will be considered from a business point of view. Your personal net worth could be in the millions and your credit record pristine, but this will not have much bearing on the lender’s decision.

The most common type of debt financing is a bank loan. The interest rates may vary from one financing institution to the other. You must do your research prior to deciding on what loan to take out. The reality of these commercial loans is that the bank will often demand collateral.

The next type of debt financing is bond issues. The most common kind of bond issue is the traditional bond, a debt instrument in which investors take on the role of creditors by means of loaning money to your business entity, but for all practical purposes, they are purchasing marketable instruments that can be sold and traded. A bond certificate has value, a term. and a variable or fixed interest rate that the company must pay until maturity.

Bonds are widely used for debt financing by all kinds of organizations. The global bond market for sovereign debt instruments is estimated to be worth more than $100 trillion, which is considerably more than the value of the major equity securities exchanges on Wall Street. The American corporate bond market is about $9 trillion.

Another type of bond issue is the debenture. A debenture is an unsecured loan certificate issued by another business entity, backed by general credit rather than by specific assets. 

Historically, the third type of common bond issue was the bearer bond. The bearer bond stated that whoever held the bond was owed the money. It was eventually outlawed due to its use for tax evasion.

Is Debt Financing For You?

It is important to consider all of your options in deciding how to finance your corporation. Attempting to acquire future financing will be impacted by your previous financing. For example, banks look to the leverage of your corporation. 

Leverage refers to the amount of debt in the firm or corporation. If your corporation is highly leveraged, that means your corporation has a high debt to equity ratio. Banks may be more wary of financing highly leveraged corporations.

Business owners who are not comfortable with carrying debt on a personal level may be skittish about getting their companies into debt. We say they shouldn’t be. Many entrepreneurs who accept debt financing find themselves motivated to generate sufficient cash flow to cover interest payments. Others like the idea of company bonds becoming more valuable as their businesses mature and expand.

Examples Of Debt Financing

A business owner who takes loans from family members to get her business started is, in fact, using debt financing. This is on a smaller scale, usually. 

A waterfront municipality that floats a special bond issuance for the purpose of building a maritime port is another example of recurring to debt financing. An entrepreneur who inherits $100,000 can loan his own startup company $5,000 to cover initial incorporation costs and operating expenses.

Equity Ownership

Banks and other commercial lenders swear by the traditional process of collecting interest, charging fees, and perhaps cashing in on collateral assets in case things do not work out. In contrast, business investors tend to be more interested in equity ownership, which is essentially a certain degree of claiming the right to own a company. Equity ownership is exercised by holding shares of a company, which are more commonly referred to as stock certificates.

When you finance your business venture through equity ownership, you are in fact selling part of it, and you will no longer be a sole proprietor. The stock of your company will have an initial value that could rise or fall in accordance with business operations and market conditions. 

In some cases, equity ownership can be transferred very dynamically. The legal structure of the company is key when settling on equity ownership. In Florida, business owners must follow chapter 607 of the Business Corporation Act and adhere to the rules set forth by the Secretary of State.

Improve Debt Financing For Your Small Business With Trembly Law

Trembly Law is ready to help you with managing credit scores. Our lawyers will consider all of your options regarding how to finance your corporation. There are various options available with regard to both debt financing and equity financing. Understand all of the benefits and detriments of both types of financing. Feel free to get in touch with our office and learn more about debt financing. Consulting with an experienced legal team can help you truly understand the implications of all types of financing.

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