Navigating Debt Financing for Your Business in 2023 (2024)

It takes money to make money; that capital often comes as business debt financing. From small startups pursuing a launchpad to established enterprises chasing expansion and innovation, debt financing provides much-needed cash to turn big ideas into realities.

However, subtle nuances make it trickier than that.

As a business owner, you’ll have to decide between equity financing, debt financing, or a combination of both. Each has benefits and drawbacks that make it better for certain business models, industries, and growth rates.

Debt isn’t a bad thing. Even the most successful companies leverage debt from time to time. Giants like Uber, Airbnb, and Whole Foods used debt financing to grow and expand their businesses.

In this article, we’ll walk you through all the intricate ins and outs of debt financing so that you know exactly what you’re getting into before you sign the dotted line.

What is debt financing?

Debt financing is a method of raising capital where a business borrows money and agrees to repay it later, often with interest. The funds typically come from financial institutions like banks or can be raised through issuing bonds to investors. This strategy allows businesses to fund operations, purchase assets, or undertake new projects without giving away ownership stakes.

Debt financing vs. equity financing

Equity financing is when you trade company shares in exchange for capital. You’re selling ownership of your business for upfront cash.

Some startups view it as free money, but it has the potential to be much more expensive than debt financing, especially if you’re successful.

Unlike equity financing, debt financing keeps you in control of your business. Instead of trading ownership of your company (forever), you pay interest (over time).

Debts get paid off. Equity financing doesn’t.

How does debt financing work?

The nitty-gritty details of debt financing vary depending on your loan type. Some feature basic repayment terms with a fixed interest rate, while others require a set percentage of your debit and credit card sales.

The best debt financing for your business will depend on your financing needs, credit score, assets, and financial situation. Below, we’ll cover some commons types of business financing options:

Business term loan

Fixed-sum loans with a pre-determined repayment period and interest rate are used for specific purposes such as expansion, capital investments, or operational needs.

Short-term loan

Smaller-term loans with shorter repayment periods and quicker access to cash are typically used for addressing immediate cash flow needs, covering short-term expenses, or bridging gaps in funding.

Business line of credit

This flexible financing gives your business access to a set credit limit you can borrow from on an as-needed basis. You can use this to cover practically any business expense, repay the amount borrowed, and get full access to the line of credit again without application or approval waits.

Equipment financing

These business loans help you purchase necessary equipment or machinery—from computers to accounting software. Your financed equipment serves as collateral, allowing you to make bigger purchases.

Accounts receivable financing

This type of financing lets you sell your outstanding invoices (at a discount) in exchange for immediate cash. Accounts receivable financing (also known as factoring or invoice financing) is perfect for keeping a healthy cash flow when clients are slow to make payments.

SBA loans

Government-backed financing options through the Small Business Administration (SBA) give your company access to affordable capital through partnering with approved lenders. While this is ideal debt financing, it’s notoriously competitive and difficult to qualify.

Business credit card

Revolving line of credit that gives your business purchasing power and expense tracking for day-to-day expenses. Business credit cards also help you build your credit history to help you qualify for bigger, better loans down the road.

Merchant cash advances

Financing option where a business receives a lump sum payment upfront in exchange for a portion of its future credit card sales, providing quick access to capital with repayment based on a percentage of daily or weekly sales.

Advantages and disadvantages of debt financing

Should you use debt financing to grow your business? There’s no one-size-fits-all answer, but we can help you understand the benefits and drawbacks of debt financing. The right financial strategy for your business will depend on your products and services, growth rate, and goals.

Understanding these nuances will help you know if it’s right for your business.

Advantages of debt financing

Access capital. It takes money to build, grow, and operate a business, and you can use the capital for everything from expansion to marketing to recruitment.
Retain ownership. Debt financing helps you keep ownership and profits. That means you get to keep the decision-making hat and are entitled to profits at a future date.
Make predictable payments. With debt financing, you know how much you owe and when you owe it, helping you plan your monthly, quarterly, and annual budgets.
Claim tax deductions. Most of the time, the interest paid on your debt financing is tax deductible, reducing the overall cost of borrowing.
Build business credit. Borrowing now can help you build your credit history, entitling you to bigger bank loans (which you might need for expansion or an acquisition).

Disadvantages of debt financing

Risk assets. You could lose valuable assets if you default on traditional bank loans.
Damage credit score. Failing to make timely monthly payments can hurt your credit score and prevent you from securing much-needed capital later.
Incur monthly expenses. Repayment terms will limit your financial flexibility, requiring you to make regular payments to satisfy your debt obligations.
Difficult qualifications. Better loans require more stringent qualifications, so you might have to accept less favorable terms when looking for financing in the startup stage.

When to consider debt financing

While it’s possible to bootstrap a business and never take on any debt, this slow-growth strategy might hurt your potential and limit your opportunities.

It can be uncomfortable taking on debt, but it can also be the best way to build your business—done correctly, of course.

Is debt financing right for your business? Consider the following circ*mstances:

Proven model. You’ve identified a lucrative market and a product-market fit. Now, you need capital to scale your business and satisfy customer demand.
Growth opportunities. An advantageous piece of office real estate might become available, or you may find top-notch talent on the market. In these circ*mstances, it might be worth taking on debt to seal the deal while the opportunity remains.
Working capital needs. If your business experiences temporary cash flow challenges due to seasonality, inventory management, or delayed customer payments, short-term debt financing options like lines of credit or business credit cards can help bridge the gap and ensure smooth operations.
Capital investments. Your business needs the necessary equipment, technology, and supplies to operate. You’ll likely need to fund these upfront investments with debt to hit the ground running.
Cash flow management. Cash flow loans can help you manage cash flow by smoothing out fluctuations in revenue and expenses, ensuring stability and predictability in day-to-day operations.

You can use an online marketplace like Lendio, Fundera, or LendingTree to submit a single application and get dozens of custom offers for your business.

Build your business with predictability

Debt financing is an investment in your business.

Growing your business with DigitalOcean is another investment. You get access to world-class cloud hosting with predictable pricing.

Ready to get started? Spend more time on your projects and less on your infrastructure by signing up for DigitalOcean.

Debt financing is different from equity financing, where company shares are traded in exchange for capital. With equity financing, ownership of the business is sold in exchange for upfront cash. In contrast, debt financing allows the business owner to retain control of the company while paying back the borrowed money over time, usually with interest [[2]].

There are several types of debt financing options available for businesses, each with its own advantages and purposes:

Business term loan: This is a fixed-sum loan with a pre-determined repayment period and interest rate. It is commonly used for specific purposes such as expansion, capital investments, or operational needs [[3]].
Short-term loan: These are smaller-term loans with shorter repayment periods and quicker access to cash. They are typically used for addressing immediate cash flow needs, covering short-term expenses, or bridging gaps in funding [[3]].
Business line of credit: This flexible financing option gives businesses access to a set credit limit that can be borrowed from on an as-needed basis. It can be used to cover practically any business expense, and the borrowed amount can be repaid to regain full access to the line of credit without application or approval waits [[3]].
Equipment financing: These loans help businesses purchase necessary equipment or machinery. The financed equipment serves as collateral, allowing for larger purchases [[3]].
Accounts receivable financing: Also known as factoring or invoice financing, this type of financing allows businesses to sell their outstanding invoices at a discount in exchange for immediate cash. It helps maintain a healthy cash flow when clients are slow to make payments [[3]].
SBA loans: These are government-backed financing options through the Small Business Administration (SBA). They provide affordable capital to companies by partnering with approved lenders. However, SBA loans are notoriously competitive and difficult to qualify for [[3]].
Business credit card: A revolving line of credit that gives businesses purchasing power and expense tracking for day-to-day expenses. Business credit cards also help build credit history, which can be beneficial for qualifying for larger loans in the future [[3]].
Merchant cash advances: This financing option provides a lump sum payment upfront in exchange for a portion of the business's future credit card sales. It offers quick access to capital, with repayment based on a percentage of daily or weekly sales [[3]].

Debt financing offers several advantages for businesses:

Access to capital: Debt financing allows businesses to obtain the necessary funds for various purposes, such as expansion, marketing, or recruitment [[4]].
Retain ownership: Unlike equity financing, debt financing allows business owners to maintain control and ownership of their company [[4]].
Predictable payments: With debt financing, businesses know how much they owe and when they owe it, enabling better budget planning [[4]].
Tax deductions: In most cases, the interest paid on debt financing is tax deductible, reducing the overall cost of borrowing [[4]].
Building business credit: Borrowing and repaying debt can help businesses build a positive credit history, which can be beneficial for future loan applications [[4]].

However, there are also some disadvantages to consider:

Risk of asset loss: Defaulting on traditional bank loans can result in the loss of valuable assets [[4]].
Credit score impact: Failing to make timely monthly payments can harm a business's credit score, making it more difficult to secure future capital [[4]].
Monthly expenses: Debt financing requires regular payments, which can limit financial flexibility [[4]].
Qualification challenges: Securing better loan terms often requires meeting more stringent qualifications, which can be challenging for startups [[4]].

When considering debt financing for your business, it's important to assess your specific circ*mstances and needs. Debt financing may be suitable if you have a proven business model, growth opportunities, working capital needs, capital investments, or cash flow management requirements [[5]].

Remember, it's always a good idea to consult with financial professionals or advisors to determine the best financing options for your specific business situation.