While larger, long-established businesses can rely on traditional bank loans to fund growth initiatives, small and middle-market businesses must rely on other types of debt financing.
In large part, the reason comes down to the broadening influence of federal regulation.
Ever since the 2008-09 financial crisis, investment banks and traditional lending sources have been less and less willing to lend to small and medium-sized businesses. Instead, they now overwhelmingly favor established businesses with a consistent history of cash flow, sufficient collateral, and a favorable debt-to-income ratio.
Companies with a short history of operation or poor credit history may be entirely unable to secure a bank loan. To make matters more complicated, frequent declines for a loan could decrease your chances of landing another one from the same institution.
Yet that doesn’t mean you’re out of luck. Over the past decade, small companies have sought out financing from alternative sources of debt financing. Not only is it now easier to secure capital outside of banks, but many companies actually prefer these other types of debt financing due to their relative flexibility.
Common sources of debt financing include business development companies (BDCs), private equity firms, individual investors, and asset managers.
As of 2019, there were 30.7 million small- and medium-sized enterprises (SMEs) in the United States, comprising 99.9 percent of all businesses. They employed 59.9 million people (just shy of 50 percent of the entire workforce).
Expanding companies typically consider three primary financing options: equity, debt, or a combination of the two. While equity financing requires sacrificing ownership stake, debt financing involves raising capital through fixed income products like bonds, bills, or notes.
Many company owners prefer debt financing over equity financing since it doesn’t require ceding shares and carries certain tax advantages. Both principal and interest may be written off as business expenses while specific deductions can reduce a company’s overall tax rate.
Debt financing isn’t just a single term, either. It encompasses a whole ecosystem of distinct funding approaches. Depending on your funding goals, the right financing for you could comprise a multi-layered strategy.
With that said, let’s jump into the primary types of debt financing that most mid-sized companies seek out.
Types of Debt Financing to Consider
Non-Bank Cash Flow Lending
When banks evaluate companies for traditional loans, they analyze a broad set of factors, like credit history, investment history, assets, and profit. Banks seek to minimize risk by determining your future capacity to pay them back.
Non-bank cash flow loans work similarly, yet are approved based on a much smaller set of factors. Lenders use the company’s cash flow rather than their assets to determine loan viability.
The company may also be reviewed on facets like transaction frequency, seasonal sales, expenses, customer return rates, and even online reviews. Most lenders decide within one to three business days, providing companies capital ranging from $5,000 to $250,000.
Loans can be paid off either as a percentage of the sales you make until the principal amount is paid off or as a fixed amount over a predetermined period. While this level of flexibility is nearly impossible to find in bank loans, it’s much more common in other sources of debt financing.
Sound too good to be true? Companies need to be careful about the lenders they turn to. Since cash flow loans are considered riskier, some lenders charge higher interest rates or hidden fees. Always opt for a reputable lender with a proven track record for enabling company success.
Recurring Revenue Lending
Recurring Revenue Lending, otherwise known as SaaS (Software as a Service) credit, funds companies as a function of their monthly recurring revenue (MRR). Your accessible amount changes based on the revenue garnered through customer subscriptions.
MRR loans are structured as a line of credit that can be borrowed and paid back whenever needed. Additionally, companies aren’t required to pay back interest if nothing is borrowed.
MRR funding is an excellent option for businesses that boast a proven track record of retaining customers for recurring services. The option is especially recommended for those with few assets that are growing their revenue stream faster than 20 percent annually.
High-margin, high-growth businesses with a SaaS structure rely on MRR financing to increase their cash runway, or the length of time the business will remain solvent if they are unable to generate any additional revenue. Recurring revenue is highly attractive for companies seeking to finance rapid growth without adding more shareholders.
Reputable lenders audit the company’s historic and current revenue streams to determine eligibility. Though requirements vary, most companies are required to maintain a renewal rate of 75 percent or higher to qualify.
Of course, research is vital: Some lenders charge extra fees for underutilized lines of credit so make sure to do your due diligence before settling on a financing partner.
Loans From Financial Institutions
While bank loans are hard to come by for small and middle-market businesses, we would be remiss to not include them in this list.
After all, of the many types of debt financing, traditional financial institutions are still one of the most common providers. To qualify, companies need to adhere to a strict set of requirements, boast robust credit history, and feature long-term investment history. Banks are much more likely to lend to established businesses with a proven track record of success.
There are three types of long-term loans: business, equipment, and unsecured loans.
Business loans are intended for virtually any company goal. The loan may be provided for a specific purpose, such as onboarding new staff, or with no strings attached.
Equipment loans are more specific, used to buy, replace, or upgrade company assets. The company may be asked to prove that the purchased equipment would produce an immediate return on investment through a documented reporting process.
While a secured loan requires collateral guaranteeing repayment in the case of dissolution, it features a lower interest rate for easier repayment over time. If the company goes bankrupt, the secured creditor will realize a larger portion of their claims compared to any unsecured creditors.
By contrast, unsecured loans don’t require any collateral, yet do require an extensive financial assessment. Most lenders will want the borrower to demonstrate a minimum income over a fixed period to qualify. Additionally, it’s not possible to extend an unsecured loan beyond ten years.
Loan From a Friend or Family Member
Many businesses get their feet off the ground through investments from friends and family members. These loans typically come with much looser terms, providing startups with their first real-world funding and investment experience.
Low interest rates, minimal paperwork, and immediate capital — what’s not to love? While it may be easier to secure than a bank loan, family loans carry significant reputational risk.
Companies must carefully evaluate their needs and ability to pay off a family loan. Would you be able to pay back your friends in case of bankruptcy? Are your friends fully aware of the financial risks of investing in your business? Do you have a clear idea of how the capital would help grow your operation?
To avoid the most common risks and pitfalls associated with this type of debt financing, it’s wise for startups to go into family loans with a detailed plan for how they plan to pay off their debts to family and friend investors.
Peer-to-Peer Lending
Peer-to-Peer (P2P) lending rose to prominence with the birth of sites like KickStarter, Prosper, and GoFundMe. As one of the most accessible alternatives to family financing, P2P lending matches borrowers with individual lenders that believe in the company’s services.
This lending option is most appropriate for small startups comfortable revealing their financial details publicly. Some online platforms may require detailed financial statements, revenue projections, or evidenced assets.
Of course, P2P lending can damage a company’s reputation if they’re unable to produce a return or provide a promised product. Perhaps most regrettably, peer lending services don’t offer the professional guidance and flexibility that established alternative lenders do.
Home Equity Loans & Lines of Credit
Provided the borrower has real estate equity and good credit, it’s easier to secure a home equity loan than a traditional bank loan. A home equity loan is a one-time cash infusion that’s repaid at a fixed monthly rate, similar to a mortgage.
Compared to other types of debt financing, home equity loans are highly predictable funds repaid at the same amount every month. That said, payments will be higher since borrowers repay both interest and principal over time.
Alternatively, a home equity line of credit allows borrowers access to a set amount of cash that they can optionally draw from whenever needed. Interest isn’t charged until funds are withdrawn; however, the interest rate charged may be variable depending on the prime rate.
Since the loan is secured by property, home equity interest rates are far lower than standard bank loans. The average interest rate is just 6 percent, compared to the average 8 to 10 percent interest rate associated with bank loans. Better yet, the interest is tax-deductible if used to improve borrower property.
Borrowers should have sufficient means to pay off the loan since company property is put at direct risk. The loan may also incur inactivity fees, closing costs, and unforeseen attorney fees.
Credit Cards
Business owners have long used credit cards to build their companies and create trust with future lending associations.
Small business credit cards are guaranteed personally through the buyer, meaning that established business credit isn’t required to use one. Many come with favorable introductory offers, such as 0 percent APR for the first year.
Credit cards can also ease the burden on small accounting departments since a single monthly bill is paid out rather than dozens of unrelated invoices. Some cards offer cash-back or points rewards that can be used towards travel and other business expenses.
Of course, the drawbacks can be significant; credit cards incur high-interest rates for cash advances and late repayment.
Bonds
Bonds are essentially loans taken out by companies, government agencies or other organizations, the twist being that the capital comes from those investors who buy bonds from the company or organization. That company then pays out interest regularly — normally every six to 12 months — and when the bond reaches maturity, returns the principal.
Short-term bonds, issued by companies that have immediate needs, mature within one to three years. Medium-term bonds typically reach maturity in 10 years or more, and long-term bonds — issued by companies that require funding over an extended period — can stretch 30 years or more.
Bonds can be secured or unsecured — i.e., backed by collateral or not — and they differ from stocks in that a bond’s characteristics are determined by a legal document known as an indenture, an agreement between the two parties.
When companies are unable to net a bank loan, bonds solve the problem by allowing alternative investors to become lenders. Lenders can either buy bonds or sell them to potential investors.
Debenture
A debenture is similar to a bond, the biggest difference being that debentures are backed not by collateral but rather by the reputation of the borrower. They are, in other words, high-risk but also high-reward, paying higher interest rates than standard bonds.
As with bonds, the borrower issues an indenture to the lender, outlining the details of the loan, maturity date, interest rate, etc. While the terms vary from one debenture to the next, they typically run longer than 10 years.
The Verdict
While the ’08-09 recession forced small and mid-sized businesses to get creative in order to meet their financing goals, there are many sources of debt financing available today to fill the gap left by banks and traditional financial institutions.
There are, of course, several factors a business leader must weigh before going that route. A big advantage to debt financing is that a CEO will maintain control of the company’s operations and direction, and not be forced to sacrifice it to investors. There are also significant tax advantages, the most notable being that the principal and interest on corporate loans can often be written off as business expenses.
The cons are no less obvious. First and foremost, the debt must be repaid. There are also such matters as high interest rates and the potential impact on a company’s cash flow and credit rating.
Generally, though, it is an option worth considering. As with other alternative lenders, those in the debt-financing realm can be more flexible than banks, and can more readily meet the needs of small and mid-sized businesses to help them grow.