When closely held businesses need capital, they generally have two options — getting a bank loan or seeking out private investors. While a loan isn’t going to be a viable solution for every liquidity need a business has, it can be significantly less expensive in the long run than equity capital. If you’re needing cash now or in the future, it’s important to know the basics of how to think about debt for your business.
How SMEs benefit from business debt
Small businesses often turn to debt financing as a cost-effective solution for their capital needs. While business debt can be an attractive alternative to equity financing due to its lower costs, it’s important for entrepreneurs to recognize that it’s not suitable for every financial need. This choice involves leveraging the business’s assets to secure necessary funds without giving up an ownership stake. Here’s a closer look at why small businesses might choose to finance themselves with debt:
- Debt financing is generally less expensive than bringing in investors, making it an appealing option for businesses looking to preserve equity.
- Bank debt serves to temporarily transform an illiquid asset, like real estate or equipment, into liquid capital that the business can use for various needs.
- Loans are secured by the business’s assets, which means that regardless of how the funds are used, the obligation to repay the loan remains secured by the value of the collateral.
- A bank’s involvement with a business is limited to providing and collecting debt, avoiding any influence over the company’s management or entitlement to its profits and losses.
How debt is different from equity capital
Equity investment, on the other hand, is money added to a business venture in a partnership role. If the invested money is spent on, say, sales and marketing, and great success results, then the investor will have a share of the profits.
If results don’t turn out as hoped, the investor will similarly bear partial responsibility for the losses and not expect the investment to be repaid. For this reason, equity investment is known as “loss-absorbing” capital. Business debt is specifically not meant to be “loss-absorbing.” Once you pay back the money you’ve borrowed, plus interest and fees for the use of the money, you and the bank go your separate ways until the next time you have a need. Unlike an investor, you also don’t have to worry about a banker looking to achieve a greater return than expected or pressuring you to run your business in a certain way.
This characterization of debt and equity investment describes two ends of the spectrum. There are lots of hybrid structures in the market.
And, if you’ve developed a healthy relationship with your banker, you may find them to be a helpful resource between the periods of time when you are an active borrower.
How to start looking for a loan
Start by doing your homework.
Securing a loan is a crucial step for many businesses in need of capital. It requires strategic planning and a willingness to engage with multiple banking institutions.
- Since bank loans are backed by collateral and expected to be repaid in a specific period, develop a detailed plan for how you will deploy borrowed money and pay back the loan on time, regardless of what happens in the future.
- Not all banks lend to every type of business. Learn all the bankers in your business community who might be organized to lend to your type of business and to accept your type of collateral. There are worse things than to Google which banks are active in your community, then network your way to introductions.
- Keep in mind that banks manage loan portfolios, and any specific bank’s portfolio might include over- or underweight loans like the one you represent on any given day. You will not know this until you ask, so be prepared to check in with as many of the relevant bankers as possible.
- A bank’s job is to assess risk, and groups of people with different perspectives are proven to make better risk-assessment decisions than individuals. Know and be patient with the fact that your first discussion with a relationship-oriented banker will be followed up by direct or indirect discussions with other people in the bank who are responsible for being skeptical.
- Prepare yourself to take no for an answer. You and the lender are both looking for a fit between the characteristics of your business and the specific appetite of the lender. There will not be a fit with everyone, so don’t force it — learn and move on to the next opportunity. This will feel hard unless you have intentionally created multiple opportunities.
When your homework is done, get out and talk to as many potential lenders as possible.
When and where relationships matter
Relationships matter after your homework is done, not before.
Risk assessment and loan pricing is part science and part art. And it’s about the future, which will inevitably turn out differently than we expect. The place for relationships is when you and the bank have both listened to each other carefully and established a business relationship based on openness and absolute integrity.
So, as you look to finance your business, be present and trustworthy above all else because having those attributes will tell a banker more than numbers ever can. Then, when things go differently than expected, you have the foundation for solving problems together.
Do not rely too heavily on what many believe to be salesmanship, which is really just painting an overly optimistic picture. In our experience, businesses have far more relationship success when they help their banker understand the possible downsides, which are a part of every loan.
How Oaklyn Consulting can help
Our mission at Oaklyn Consulting is to help businesspeople deal with money people.
When a business needs capital and is struggling with the task of getting it, we help organize the job of shopping for capital. Whether it’s navigating business debt or equity financing options, our expertise guides businesses through the complexities of acquiring funds. Sometimes, a business will have financial needs that require the assistance of investors as well, and if so, we can also assist in that marketing process and help evaluate options.
