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Types of Debt Financing for Small Business

Author: Imagination Date: March 01, 2010

See the other top 10 most popular how-to posts on NFIB.com in 2010Debt financing involves borrowing money from a lender with the understanding the borrower must pay the lender back, usually with interest. (Read about its difference from equity financing.)  Debt financing can fund a startup, help a growing firm that needs money for expansion or get a veteran company through tough economic times

There are several types of debt financing--some that work for startups, others that work for well-established firms. But your options definitely go beyond the typical bank loan. They include:

Factoring

To have immediate access to cash, a business may be able to sell a percentage of its accounts receivable to a factoring company, which then collects the money from the customer. The factoring company does not always assume ultimate responsibility, though, if the customer ends up not paying. The debt must be paid back to the factoring company, plus interest, which is often quite high.

Trade Credit

Businesses can receive "trade credit" from their suppliers by negotiating the option to pay later. Say an office supplies retail startup needs inventory before opening its doors. The office supplies wholesaler could sell products to the startup, but instead of asking for immediate payment, extend the payment terms to 90 days. That way, the startup could use revenue toward the purchase. (Suppliers usually offer a discount if the debt is paid earlier.)

Bank and Credit Union Loans

Also called "term loans," bank and credit union loans are the most well-known type of debt financing available to small businesses. These loans typically require monthly payments on the principal plus interest. However, traditional business loans can be difficult for a startup, or even established small businesses, to obtain for lack of collateral or a long credit history. (That's why it's important to know about other forms of debt financing.)

Loans from Relatives – or Yourself

Business owners can take money from their relatives or personal funds without exchanging the amount for equity in the company. Instead, a formal agreement--though repayment terms are often flexible--is spelled out by both parties to acknowledge the capital infusion is debt, not equity. Peer-to-peer lending is another form of debt financing that doesn't require the participation of a traditional financial institution. Sites like Prosper.com and Peer-Lend.com have surfaced in recent years to facilitate these transactions.

Overdraft Agreements

Also called "overdraft lines of credit," overdraft agreements can be established between a business and its bank. The bank establishes a limit to the account, and the business owner is allowed to withdraw up to that limit--even if there are insufficient deposits to cover the amount. The overdraft amount is charged interest that needs to be repaid along with the principal, and can be as high as the prime rate plus 5 percent.

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