The Difference Between Debt & Equity Lenders
And why it matters to your business.
There is a multitude of ways to fund a business. Two of the most common ones are debt financing and equity financing. But what are the differences between the two? What are their advantages and disadvantages? What does it matter to your business?
For a business to operate, it has to have capital, especially working capital. Capital is the term used when referring to the cash a company has on hand so it can function. Working capital is the money used to cover a company’s short-term expenses, which are due within one year. It is the difference between current assets and current liabilities.
Most companies use working capital to purchase inventory, pay the short-term debt, and for day-to-day operating expenses. Many companies utilize either debt or equity financing, or some combination of the two, to obtain capital to cover immediate funding needs while customer invoices are waiting to be paid. Once the invoices are paid, the debt is retired and the cycle begins again. In most cases, a company will establish a line of credit with a lender or have the lender create a credit facility that can be drawn upon, as defined by the needs of the business.
Rapid access to cash on a recurring basis can be extremely advantageous to a business as it works to cover short-term expenses and is an easier solution than negotiating a loan from the bank every month. This financing generally breaks down into two categories:
Debt financing is capital obtained from a loan. There is an expectation that the borrower will need to repay the loan according to the lender’s terms, but the business owner doesn’t give up any portion of the ownership or control of the company to receive this capital. Very often there is a collateral component to debt financing either in the form of inventory, accounts receivables/invoices, real estate, or business assets.1
Equity financing comes from the funds obtained through a sale of a portion of the business’ equity to an investor. Equity financing is generally the type of funding provided to a company from venture capital or angel investors. Unlike debt financing, there’s no expectation or obligation for the business owner to repay the investor for this purchase. Depending on the arrangements made during the investor’s acquisition of a percentage stake in the business, the investor may obtain partial (or even full) control of the business or the board of directors. 1
Interest rates can vary from lender to lender and loan to loan. Be sure to read the terms of your agreement and negotiate where you can to be sure the finance package you put together is mutually beneficial to you and the lender. As interest rates rise and credit markets tighten, banks tend to lend less, so understanding the terms of your loan is extremely important.
The most important part of the funding process is finding the right partner to help you meet the needs of your business. The right lender will put together a package to meet your needs and be there as a partner to your company through both the good and lean times.
Can a borrower utilize points or lender credits with a business loan? The answer is yes, and the advantages / benefits are much the same as they are for personal loans.
Buying points on a commercial loan can lower monthly repayments and potentially save your business money over the life of the loan. Lenders may offer better interest rates and terms to borrowers who buy points. Points can benefit companies which are just starting out, having cash flow issues, and in many cases, point fees can be tax deductible. Be aware however the purchase of points may require a large upfront cash payment. For example, one point is usually calculated at 1% of the total loan amount so one point on a $1 million dollar loan costs $10,000. If the loan is only for a short term, then any interest savings may be small and not worth the upfront fee.
If your business is well established and has a solid monthly cash flow, then you might consider removing upfront costs by getting lender credits. By removing these upfront costs as a result of lender credits, you agree to pay a higher interest rate and higher monthly repayments. If your loan amount is high, then removing closing costs and fees could represent large initial cash savings but result in higher payments. If your loan term is short, then any additional interest charges may be low or manageable.
Lenders use points and credits to cover the risk and costs associated with originating a loan. Different lenders offer varying interest rates and terms so it’s a good idea to check with a number of lenders to find the best deal for your company.
If you’re considering using points or lender credits, make sure you understand the impact they will have on your monthly repayments and cash flow. It’s always a good idea to have an attorney review a loan contract before signing.
Is There an Advantage to Buying Points or Using
Lender Credits on a Business Loan?
If you’ve ever taken out a personal mortgage, you’ve likely heard of loan points or lender credits. Loan points are fees paid by a borrower to reduce the interest on a loan, while lender credits reduce or remove closing costs on a loan in exchange for the borrower paying a higher interest rate.
Funding Strategy Spotlight:
An SBA loan is a means for approved financial institutions to provide funding to small businesses. These loans are guaranteed by the U.S. Small Business Administration (SBA) and offered at very competitive interest rates. An SBA loan is an optimal solution for funding in situations where a small business might not qualify for a regular bank loan because of a lack of credit history, poor credit, or because of the size of the loan.
The SBA created this program to help foster growth, competition, and innovation in the marketplace. Loan guarantees can range from $500 to $5.5 million and can be used for most business purposes, including long-term fixed assets and working capital. Depending upon the loan program you qualify for through the SBA, interest can even be deferred by months or even years. Not only do many SBA loans come with competitive terms, in some instances they have lower down payments, do not require collateral, and can be combined with other funding sources.
Having an SBA loan can be an essential part of any sound business plan. Utilize the resources you have available and talk with finance experts, business leaders, and market strategists to determine how an SBA loan might benefit your business. Smart funding choices can put you and your small business on the road to success.
To learn more about funding through the SBA program, visit www.sba.gov or contact us at email@example.com and we can provide you with a list of SBA-approved consultants to help you on your way to an SBA loan.
Click to watch webinar on Interest Rates:
The Real Cost of Doing Business
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