When you look for money to finance your startup business, your own funds are not the only option. There are plenty of debt financing sources that can lend money to your business without diluting your ownership. In fact, as your startup business grows, you need more money to finance it, and your own financial sources may be limited. Plus, debt finance is usually cheaper than equity finance. By more debt in your company, you can even achieve higher returns for yourself. You may think that it is not logical. How can the fact that you owe money make your returns higher? Let's see how debt can help your company.
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It's all about the leverage
Imagine that you have $100 and you invest that into your business. Let's say your business earns you 10% profit, that's $10 on $100 investment. You don't have any debt, so the $10 profit is all yours. Now imagine, that you will be able to borrow another $100 from a provider of debt financing. The interest rate on that debt will be 5%. You will invest that $100 of debt into your business, so together with your own money you invest $200. Again, your business makes you 10% of profit, in this case that is $20. Of course you have to pay interest of 5% on your $100 loan, which is $5. So your return will than be $20 minus $5, that is $15. You invested $100 of your own money and earned a profit of $15, so your return on investment is 15% compared to 10% in the situation without debt. That extra return is the return from leverage. As long as the financial costs of debt (interest) is lower than the profit that your business makes, you will increase your return on investment by introducing more debt into the financing of your business.
But, it's not so easy as it seems
Sounds like miracle, doesn't it? But it's actually not that easy. The more the business is leveraged, the riskier it is. What if your business will suddenly start generating less profit and those profits will be lower than the interest rate on your loans? If your business will stop performing, the heavy debt burden can ruin it when you fail to meet your debt obligations. Plus, the higher the leverage, the higher the interest rate on additional loans is likely to be as the borrowers will incorporate risk premiums into the interest to compensate for the increased risk of borrowing more money to the indebted company.
So your business needs to find the right balance between equity and debt financing, which is called the optimal capital structure. This differs from industry to industry, country to country or by the size of the company, so look for your sweet spot when deciding on your projected capital structure.
How this will help my startup business?
So we have seen that debt can be useful in the company's capital structure, but startups face another issue related to debt financing. Even if they would like to get some debt into their financing, they will hardly get any loans in their early stages. Banks will not borrow money to new companies without history, proven sales records and well-tested business concept. So what can startups do to get some debt financing? There are still some options, specifically, there are various government support programmes to help startup companies to get their business up and running. They can provide micro loans, special loans to startups, grants or mezzanine financing. And as your business will grow and build up some history, you can approach the traditional debt financing options such as bank loans or senior and subordinate notes. Or, and that's the best options, the borrowers will find you, rather than the other way around.What's next? Model the debt financing into your financial projections!
Next time we will discuss how to model debt financing in your financial model and will have a look at the options that are available in Feanut Financial Model for debt modeling. In the meantime, if you want to know more about building financial model for start-ups, you can still use the offer to join our Startup financial modeling online course with a discount for first 100 students.
This post first appeared on Feanut - Financial Modeling Blog For Startups, please read the originial post: here
