By Samantha Novick
The two most common ways business are able to access capital are through debt or equity financing. Each option has its own unique advantages and disadvantages but, for most small businesses, debt financing tends to be the most accessible. Venture and angel capital made up less than 2% of funding for small businesses in 2015, while 73% of small businesses used financing over the course of the year. Business debt also has a number of benefits you should understand.
Ownership Stays with You
With debt financing, a lender loans a business upfront capital with the agreement that the business will pay the principal back plus interest at a later date.
Selling equity is, at its core, selling a piece of your business. With equity financing, a business trades a stake in their business for a specific amount of money. This gives the investor a percentage of the business and its profits, and in most cases, a say in decision-making.
So, if you choose to finance with debt, assuming you pay off the loan on time and in full, ownership (and profits) stays with you. If you choose to finance with equity, your investor receives a portion of your profits, as he or she gave you money in return for a portion of your business.
Saves Money on Taxes
Interest on debt is a tax deductible expense which means—if properly accounted for—a business financing with debt can receive a substantial discount on its interest paid.
If, for example, a business borrows $20,000 with an interest rate of 8%, they’ll owe $1,600 in interest at the end of the term. If we also assume that same business’s tax rate is 40%, reporting that interest as an expense on their filing will save them $640 ($1,600 x 40%).
The allows interest to be treated as a deduction as long as:
- The interest is directly related to the business
- You are legally liable for the debt
- Both you and the lender intend that the debt be repaid; and
- You and the lender have a true debtor-creditor relationship Tax savings alone won’t make debt financing the right choice for you. But when comparing the interest costs of debt against the ownership stake surrendered with equity financing, you should always factor in the money you’ll save on interest.
Using Debt Can Improve Your Credit
Unlike using equity financing, taking on debt and paying it off responsibly can improve your credit. And whether you do or don’t rely on your credit for business financing now, there may be a point in the future when you’ll need to.
How debt financing can improve your credit
Your credit score helps financial institutions and lenders assess the risk of extending credit to your business. The most important component to building credit is taking on debt and paying it off on time. Debt in this case can assume many forms — a lines of credit, a term loan or a business credit card. (Having a mix of different accounts can actually boost your credit further.) If a potential lender sees that you’ve taken on debt in the past, and were able and willing to pay it off responsibly, it increases your likelihood of not only being approved for a loan, but receiving better terms on your offer.
When a business finances with equity, its payment to the lender is a stake in the company and not incremental monthly payments. Equity exchange doesn’t show an existing history with debt and therefore does not affect or improve credit.
It’s important to take into consideration that both your personal credit score and business credit score are key considerations for lenders as they evaluate your business. Taking the time to separate your business and personal finances (if you haven’t already), and handle any unpaid debts.
Other factors that affect business credit
Debt payment isn’t the only factor considered during business credit scoring. Several additional debt-related elements are also scrutinized during a loan application.
Percentage of available credit in use is an important element of credit scoring. If, for example, you’re using 90% of your available credit lines, a lender may be unwilling to lend to you beyond what he thinks you can pay off. New inquiries are also considered for a similar reason. If a business has applied for lines of credit from five different businesses in one month, for example, a lender might see this as a sign of desperation.
Debt financing offers several advantages that every small business owner should know about. Before jumping into the process, you’ll want to be sure to determine exactly how much money you need as well as how much you can afford. And no matter what form of debt financing you seek, be sure to read the fine print to confirm if it’s the right choice for you.
Samantha Novick is the Social Media Manager at Bond Street, a company transforming small business lending through technology, data and design.