The headlines might be dominated by startups raising big rounds from venture capitalists, but traditionally businesses were – and in many cases continue to be – built using debt. The difference is super important. Whilst equity financing entails selling shares in the company to investors, debt financing raises money by taking on some form of loan that has to be paid back – with interest – at some point in the future.

Traditional bank loans are one of the most common types of debt for businesses – but to get one, your business will probably need a few years’ track record and you might still have to make a personal guarantee to get that loan. Newer debt products are emerging, though, that provide access to finance based on revenue likely to come in (from purchase orders, recurring revenue or accounts receivable). They might be a better option for a business that hasn’t been around as long – provided it’s already making some money.

No matter a business’ size or scale, debt financing has its uses – be it refurbishing premises, upgrading equipment or getting advances on sales invoices. And whilst banks are often the first port of call, long gone are the days when they were the only avenue. Online P2P lenders, startup grants, invoice factoring and hire-purchase loans are all viable ways of raising cash.

The main benefit of debt, contrasted with equity financing, is pretty clear: no dilution of ownership or control in the business. However, debt is really only suitable for businesses that are already generating revenue, or that will be very soon. And how cheap it is compared to equity will depend on the terms you secure. It could be worth shopping around to see if you can get a good deal as interest rates in most countries are low right now – just make sure you’re absolutely clear on how much it might end up costing you.

COST OF CAPITAL // Whether you’re using equity or debt to finance your business, you have to pay it back. The ‘cost of capital’ is exactly what it sounds like — the cost to the business to take on those external funds. There are equations to work out the cost of debt, cost of equity or a weighted combination of both, but the key thing to remember is that the cost of debt is interest, and the cost of equity is the eventual value of the proportion of your business you give up to get that crucial capital.

The vast majority of loans are secured – meaning to get the loan, you need some form of collateral. That could be equipment, real estate, inventory, accounts receivable or a personal guarantee. Repayments have to be met even if the business falls on hard times or fails.

There are three main lengths of loan: short term (paid back within 6-18 months); medium term (paid back within 3 years); or long term (paid back within 5 years).

The cost of debt depends on interest rates – and these vary. They can depend on macroeconomic conditions, your business or personal credit history, and the loan type. Interest rates can range from 2.5%, for government-backed loans, to eye-watering triple digits (!) for some merchant cash advances.

As a result of Covid-19, there are government-backed loan schemes worth noting. In the Australia, there are many resources available depending on what State you are based in.

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