A guide by Brittany Peck, esq.
How Does Debt Financing Work- An Overview
Obtaining funds through debt financing means acquiring capital by borrowing from financial institutions with varied levels of risk. This method involves securing a loan from a bank or lender, to be repaid according to a predetermined schedule, often through monthly or weekly payments. In return for the borrowed amount, interest is owed to the creditors. While debt financing presents numerous benefits compared to traditional equity methods, its primary advantage lies in businesses retaining full ownership without diluting equity to secure investments.
Advantages versus Disadvantages of Debt Financing
The advantages of debt financing for your business include maintaining control of your company, making tax-deductible interest payments, making it easier to plan for the future, and building business credit. Debt financing allows the business to maintain complete control because a lender has no part in running your company. In most cases, the interest payments that your company pays for your debt financing will be tax deductible as long as you are paying it to an actual lender. Due to the debt financing structure, you will know how much you must repay each month. Lastly, when your company makes on-time payments to your debt financing option, it can help establish and maintain your business’s credit.
There are also disadvantages associated with debt financing, including that the business assets can potentially risk investments or credit history, that debt financing could create a financial strain on the business, and debt financing can be challenging to qualify. One significant disadvantage of debt financing is that it can be risky to both your company and personal infringes because one must place their business assets as collateral or sign a personal guarantee. Like many types of debt, you will have to make on-time and consistent payments on your loan regardless of that month’s revenue. Although debt financing is much easier to qualify for than equity financing, obtaining debt financing offers the most competitive terms and rates can be difficult.
Short versus Long Term Debt Financing
Short-term debt financing usually has a repayment period of twelve months or less. However, standard terms can vary between different lenders. An example of short-term debt financing is using a credit card or opening up a business line of credit.
This funding category is commonly employed to handle your business’s routine operational costs. Short-term debt financing can be used for managing working capital, acquiring inventory, or meeting payroll requirements.
However, long-term debt financing is the opposite of short-term debt financing. Long-term debt financing generally has repayment terms of up to ten years and, in some cases, as long as 25 years. Typical forms of long-term debt financing include both SBA loans and bank loans.
Long-term financing is traditionally utilized for more significant investments and products, such as equipment purchases, renovating your business, acquiring an existing company, or opening a new location or franchise.
Differences between Debt Financing and Equity Financing
Debt financing is when your company borrows money from a lender and repays it with interest. However, Equity financing involves raising money from investors by selling your company’s equity, or partial ownership. Therefore, the main difference between Debt financing and Equity financing is that with Debt Financing, you do not have to give up any equity in your company in investment return, which makes it an attractive option for companies.
Proactive Debt Finance Counsel on Your Side of the Table
Our debt finance attorneys have the know-how, market knowledge, and experience to successfully negotiate and close your most crucial debt finance transactions. We’ve represented the interests of borrowers and lenders — working with private equity sponsors and their portfolio companies, emerging companies, venture capital firms, public companies, and alternative lenders in countless debt financings.
A Real-Life Example of Debt Financing
To get a better understanding of debt financing, take a look at the following example.
Joseph’s clothing store sells accessories, shirts, pants, and shoes. The business has been steady since he opened six years ago, but for the past year, it’s been booming. Lately, he’s been thinking about opening another location to expand his business, allowing him to meet demand and reach more customers at a different location across town.
Joseph possesses significant cash flow and savings to invest in his new business site, yet he approximates a requirement of at least $60,000 to cover initial expenses. Opting for a cash-secured business loan from his bank, he secures a five-year, lump-sum loan of $50,000 with a fixed interest rate of 6.2%. Joseph is content with the loan arrangement, appreciating that he can secure the necessary funds without relinquishing any ownership in his clothing business. He prefers maintaining complete control over the company’s decision-making processes. He is satisfied with repaying the fixed monthly amount for the lump-sum loan while he establishes his second location.
Is Debt Financing for Small or Large Bussinesses?
Debt financing is a good tool for both small and large businesses alike. Often, small business owners rely on expensive debt, such as credit cards, continuous cash advances, or through additional and multiple lines of credit, to get their business up and running. This type of debt cuts into cash flow and can hinder day-to-day operations. A significant advantage of debt financing is the ability to pay off high-cost debt, reducing monthly payments by hundreds or even thousands of dollars. Reducing your cost of capital boosts business cash flow for small businesses, allowing a less risky approach to the necessary money needed to get the company off the ground.
Most larger businesses already hold existing debt, and debt financing is suitable and beneficial for these businesses. Debt Financing is helpful for companies with numerous debt obligations and want to renegotiate the terms to make them more favorable for your existing company. Essentially, your company takes out a new loan to repay your current debt, allowing your company to update your lending agreement to something that works better for your company. Your company can negotiate to get a lower interest rate this way and even improve your credit score for your business in the process.
To ensure the optimal result, our debt finance experts engage comprehensively in all facets of your transaction. This includes structuring, negotiating, documenting, performing due diligence, perfecting liens, and managing inter-creditor and subordination agreements.
We provide legal representation for private equity, venture capital firms, alternative lenders, and both public and private companies across various sectors. Our expertise extends to handling intricate, multi-tranche, and traditional debt deals of diverse scales.
We collaborate closely as a unified team with lawyers from various disciplines within the firm.
AREAS OF FOCUS
• Subordinated debt and mezzanine facilities
Mezzanine debt represents a hybrid debt issue that holds a subordinate position in comparison to another debt issue from the same issuer. This form of financing acts as a bridge between debt and equity, considered one of the riskier debt forms as it ranks below standard debt but above pure equity.
• Syndicated, club, and bilateral transactions
A loan facilitated by a single lender is termed a ‘bilateral loan.’ Conversely, a loan that involves multiple lenders might be referred to as a ‘syndicated loan’ or colloquially termed a ‘club loan.’ In some cases, multiple lenders can be indirectly engaged in the same loan through sub-participation.
• Unitranche facilities
Unitranche debt or financing is a hybrid loan structure that merges senior and subordinated debt into a single loan. This format enables banks to enhance their competitiveness against private debt funds. Under this arrangement, borrowers generally pay an interest rate between the rates each loan type would typically demand.
• Committed acquisition financings
According to Acquisition Finance, “In transactions involving committed financing, the acquirer will obtain a “commitment letter” from one or more lenders that will be executed on, or shortly before, the date the definitive acquisition agreement is executed.”
• Senior secured credit facilities
Privately arranged loans known as Senior Secured Loans (SSLs) are issued to a group of banks and institutional creditors to offer companies access to debt capital. These loans typically provide a spread over a reference rate, often LIBOR or EURIBOR, thus categorizing them as ‘floating-rate’ instruments.
• Venture debt
Venture debt is a loan tailored by banks and nonbank lenders specifically for early-stage, high-growth companies supported by venture capital.
• Asset-based working capital facilities
Asset-based facilities enable a company to promptly access working capital tied to their assets. These assets may include accounts receivable or other holdings. Structured as revolving credit facilities, asset-based loans permit a company to continuously borrow from assets to meet expenses or make investments as required.
• Distressed lending
Distressed lending typically occurs when credit facilities provide borrowers with good cash-generation capacity but shorter-term liquidity issues.
• Alternative lenders
Nontraditional lenders, also known as alternative lenders, are private entities that function like banks, offering business loans. Unlike traditional banks, which burden applicants with rigorous criteria and lengthy application processes, alternative lenders provide loans swiftly and conveniently.
• Rule 144A offerings
An offering memorandum typically contains a detailed description of the issuer, including its business and financial results, and the details of the securities to be offered, as well as risk factors, a discussion of the issuer’s management, tax considerations, and other matters.
• Convertible debt
Convertible debt is when a business borrows money from a lender or investor where both parties enter the agreement with the intent, from the outset, to repay all or part- of the loan by converting it into a certain number of its preferred or common shares at some point in the future.
• Credit and liquidity support
Liquidity refers to cash assets, and credit is used to make purchases with a promise to pay later- there could be issues that arise with these two. Our firm is here to support you in solving problems with these two concepts of credit and liquidity.
• Swaps and other derivative products
Derivatives are a contract between two or more parties with a value based on an underlying asset. Swaps are a type of derivative with a discount based on cash flow, as opposed to a specific purchase.
• In-court and out-of-court restructurings
Out-of-court restructuring is about the company attempting to resolve its financial distress and insolvency concerns without the Court stepping in. On the other hand, In-Court Restructuring is a more formal, standardized process with judicial oversight.
How We Can Help You with Debt Financing
Our team of leading corporate and finance attorneys specializes in structuring and executing intricate transactions and developing innovative solutions for debt and equity capital on a global scale. Operating across diverse industries, borders, and capital structures, we offer comprehensive counsel to various capital providers, such as private equity, private credit, infrastructure, sovereign wealth, and other investment funds, along with public and private companies, boards of directors, and family offices.
In today’s dynamic business landscape, private equity sponsors seek global opportunities. Our advantage lies in the integration of our international transactional team, which allows us to address this need effectively. Through a multidisciplinary approach, we deliver strategic and tailored representation to borrower and lender clients, catering to their specific requirements across mergers and acquisitions (M&A), special situations, investments, debt financings, capital markets transactions, projects, and energy transactions, as well as corporate governance matters, on a worldwide scale.
Securing funds for your business through debt financing entails acquiring capital without relinquishing any equity. It involves generating cash flow for your business by assuming debt. Small and large companies stand to benefit significantly from debt financing, providing various avenues to secure beneficial financing without sacrificing ownership or control over business operations.
Avenues for debt financing encompass a spectrum of options, catering to different business needs and financial goals. From traditional bank loans to alternative financing options like asset-based lending or mezzanine debt, businesses can choose the best method with their long-term strategies. The advantage lies in raising capital without diluting ownership, allowing companies to maintain autonomy in decision-making while still addressing financial requirements. Additionally, with the right approach to debt structuring and management, businesses can leverage these funds effectively to foster growth, capitalize on opportunities, and enhance overall stability.