Debt is money that you borrow to run your business, which must be repaid in full, usually in installment payments with interest. The lender takes the risk that the loan may not be repaid and charges an interest rate based on that risk. Debt is usually considered a non-dilutive method of financing a business, meaning that it does not reduce your ownership position. However, if the debt does not get repaid by its due date, the lender will essentially have rights to operate your business for the purpose of recovering the loan amount.
Lenders take collateral in the form of business or personal assets to secure the loan. An asset is simply something of measurable value such as equipment, inventory or receivables, or your personal home. If your business does not grow and you cannot repay the loan from the cash flow, the lender can sell the secured assets in order to generate cash to repay the loan.
Since early-stage technology businesses usually do not have business assets that financial institutions recognize as collateral, obtaining debt for these businesses can prove difficult (even more so in a slow market). Intellectual property is not an asset that lenders recognize for collateral purposes. Therefore lenders will often require a personal guarantee from the business owner, pledging personal assets as collateral for the business loan.
Some considerations regarding debt:
- Do you have the business assets to provide the necessary collateral to lenders?
- Do you have confidence in the future cash flow of your business to repay the principal and interest on the debt by the due dates outlined in terms of the loan?
- Are you willing to risk your personal assets as collateral for your business?
Sources of debt:
- Family and friends who may be willing to lend money to the business for a negotiated period of time and interest rate.
- Banks, credit unions and other financial institutions—they provide several types of debt instruments including credit cards, leasing products, demand/short-term loans and term loans.
- Leasing companies or leasing partners of equipment providers—they may offer leases as an alternative to purchasing equipment outright. They are generally not willing to provide leasing credit to start-up organizations until the start-ups have developed a good credit track record over a reasonable period of time (for example, two years).
- Suppliers that may benefit from the longer-term success of your business might provide your business extended payment terms.
- Venture lenders (individuals or groups with a pool of money, or specialized banking organizations)—they may provide term and short-term loans to technology businesses earlier than these loans would become available from traditional financial institutions; however, these loan facilities are usually reserved for businesses that have received venture capital investment and/or can demonstrate their ability to make loan payments from cash flow.
- Specialized financing firms—they may offer innovative financing solutions for emerging companies based on customer accounts receivable balances, tax refunds, purchase orders and contract financing.
- Lenders providing financing through factoring (also known as invoice discounting)—this involves a lender providing financing in exchange for your business signing over specific invoice amounts from your customers to the lender. Typically, your customer is advised in writing of the factoring arrangement and makes their payment for the invoice directly to the lender. The lender deducts the amount of financing it provided to your business (lenders will only fund a percentage of the invoice amount which could be 50% to 58% depending on the risk profile) along with interest on the loan, and then sends the balance of the customer’s payment to your business. The interest rate charged for factoring arrangements is typically higher than the normal course of customer accounts receivable amounts.
The Government of Canada’s Sources of Financing Database supplies a comprehensive list by specific geographic region of all organizations that provide financing of all types. It offers a valuable resource for entrepreneurs considering financing alternatives and trying to identify potential lenders for their business.
Canadian Bankers’ Association. Retrieved April 9, 2009, from http://www.cba.ca/lang.php.
Canada Business Services for Entrepreneurs. Retrieved April 7, 2009, from www.canadabusiness.ca.