Raising finance is a vital part of a business’ journey from start-up to scale-up and beyond. While some entrepreneurs may opt for the investment for equity route, others may seek to approach lenders to raise finance. This approach has the advantage of meaning no equity has to be given up, but brings with it it’s own challenges too.
Some businesses will have a good experience, with the debt allowing for further investment and subsequent growth, others may have different experiences and so will take the approach of bootstrapping so as to avoid debt.
So, what are the pros and cons of taking on corporate debt? What are the risks and what are the opportunities?
The Different Types Of Credit
Contrary to popular belief, banks aren’t the king of lending. In fact, big banks are the least used source of loans for small businesses. It’s hard to measure the profitability of these loans for small businesses for reasons explained here this piece.
What we do know however is that cash flow is crucial for any business and most companies fail, do so because of cash flow issues. So, when faced with cash flow problems, a loan can be the difference between success and failure.
Even for small businesses, there are many assets against which debt can likely be raised as long as your business is profitable and well managed. For example, there’s the classic model of credit with collateral. A business will sign away assets like the company HQ as their collateral, in case they can’t make the payments.
For companies which may be smaller and perhaps don’t have assets to raise money against, another option is debt financing. With debt financing, companies secure funds without having to guarantee collateral. In this scenario, the company issues a bond or similar instrument, in return for the loan. Since there’s no collateral, an outstanding credit score is required for securing it but, when debt financing can be secured, it can be a real boost for an early stage company.
Speculating to Accumulate
Going into debt as a company can be a huge advantage. Compared to personal loans, that are usually made to secure assets or depreciating personal goods, debt for companies usually fuels growth. That’s why it can be a very smart choice to go into debt with your company, whether that’s through classic loans, or debt financing.
Credit can be used to hire more workers, secure a better place of operations, buy better equipment and even market a company better. All of these things, either directly or indirectly, lead to more revenue in the long run if done right.
Debt needs to be invested carefully however. Simply throwing money on the fanciest tools and the best staff without a clear plan for growth may not bring returns. Even if a credit line exceeds well over what a company is used to having in the bank, business owners should exercise restraint, and stick to the plan.
Overcoming a Challenging Time
Debt can also be used to help companies navigate challenges which may leave them in financial trouble, even if the business is sound. For example, ecommerce companies can struggle with a downturn right after the holiday period. Plenty more business types have an inconsistent cash flow, especially if they’re just starting out. Then there are unexpected events such as the recent pandemic, which can turn a business from being highly profitable to loss-making overnight. Such instances don’t reflect a problem with the fundamentals of the business, but rather with the extraordinary circumstances it finds itself in, as such, the business may still be creditworthy.
Debt can help pay distributors, keep subscriptions to crucial tools, and even seize on investment opportunities during downturn. But again, debt can only be valuable as long as the borrowed funds are used with care. If the funds used exceed what a company would usually make after a period of downturn, it can spell trouble down the line.
The Drawbacks Of Going Into Debt
The main disadvantage of debt financing is that repayments can be inflexible. While traditional loans can be refinanced, or negotiated based on a current situation, companies don’t have that much flexibility when it comes to debt financing.
Besides that, debt presents the same drawbacks it always did:
- A risk. Debt is, essentially, betting other people’s money on a company’s own idea’s success. If it’s not a hit, that company can run into trouble.
- It’s a consistent cost, even if revenue fluctuates. Debt requires companies to pay installments. And if their revenue drops, it can be hard to stick to the payment plan initially agreed-upon.
- It requires discipline. If the money is spent poorly, by a company or its employees, it will spell trouble for the company
Conclusion: What Companies Should Go Into Debt?
Companies that have a use for the money should go into debt. As long as a need was identified, and a budget was written, any company - small or big - can benefit from going into debt.
The risks and headaches only appear when the money is frivolously spent so it’s important to have a clear plan for investing the money, and making returns which at least match, and ideally exceed, the cost of the finance. Financial advice will be crucial here, and debt should not be entered into without first taking that advice.