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Alternatives to Debt Financing for Business Owners

 

 

Last week we took a look at the world of debt financing with a detailed explanation for our readers.  We also examined some of the drawbacks that may be experienced when using debt financing and promised our readers that this week we would look at some of the alternatives to debt financing that are available to business owners.  We clearly explained the disadvantages of debt financing so let’s take a look at what other options are available when it comes to raising business finance.

·       EQUITY FINANCING – this means selling shares of your company to interested investors or putting some of your own personal money into the company.

·       MEZZANINE FINANCING – this is a debt tool that offers businesses unsecured debt (no collateral is required for mezzanine financing) but there is a price to pay in the higher interest rate involved (usually in the 20% - 30% range).  Another drawback with mezzanine financing is that the lender has the right to convert the debt into equity in the business if the company defaults on payments.  Mezzanine financing is an attractive option for entrepreneurs because it provides rapid liquidity and the issuing bank does not usually want to become an equity holder, even though the debt can be converted to equity in the event of the company defaulting on payments.  The issuing bank is not looking to control the company, they are more interested in the high interest charges.

·       HYBRID FINANCING – this means a combination of financing options, using both debt and equity to fund business ventures.  The main challenge with this type of financing is determining the correct combination for your business.  Amongst experts, a common finance theory is the Modigliani-Miller theorem which states that in a perfect market, without taxes, the value of a company is the same whether it is financed completely by debt, equity or a combination of both.  However, on a practical level, this is considered to be too theoretical because real companies have to pay taxes and, furthermore, there are costs associated with bankruptcy. 

Any lenders or investors who you approach are likely to want to see your debt/equity ratio.  This means that you need to divide your total debt by your total equity and this is the figure that will be used by lenders and investors to ascertain just how financially viable your company is.  They are likely to want to know where their investment will stand in the event that your company is unable to overcome any financial problems and goes bankrupt.  Debt holders have a priority over equity holders when it comes to recovering funds from bankrupt companies.

 

While it’s likely that you will take on some debt in the early stages of business, you’ll need to monitor how levered up your company is in comparison with others in your field.  You can use Bizstats.com to check your debt to equity ratio against a list of industry benchmarks.