Alternatives to debt financing

Many times business owners who are seeking financing feel that their only alternative is debt financing. However, with some planning and creative thinking, you may not have to take on additional debt. It is important to make these considerations since even a thriving business can be short on cash if its money is tied up in equipment, or customers aren't paying. When considering debt, you should ask yourself:

• What are you using the money for? Are you going to use this money to invest in fixed or variable costs? Keep in mind that if you're investing in fixed costs, (such as a new piece of equipment), then you likely won't see any cash returns from it in the near-term. However, if you need the money to invest in variable costs (such as materials for the product you make or costs associated with each new client), than the debt investment should have associated cash inflow
• What are the paying habits of my customers like? This is important since customers who consistently pay on time are critical to cash flow, and the ability to repay debt. You should learn the payment habits of your customers and consider incentives to get them to pay early. You may also want to check with associations and competitors, to make sure your payment terms are in line with industry standards.
• How old is my business? This is crucial because if you are in the early stages of a company, debt financing can be dangerous. This is because you will likely be losing money at first, thereby hurting your ability to make payments. In addition, since your net income will be low, the tax advantages of debt will be minimal. Keep in mind that as your business grows and matures debt becomes a stronger option. This is because the tax advantage will be greater, your cash flow will be more predictable, and the risk you face in bankruptcy decreases since you have been operating longer.
• If you decide that debt financing is not right for you and your business, then here are some alternatives to consider-
• Equity financing-This type of financing involves selling shares of your business to interested investors, or putting your own money into the company. The major advantage to this is that you will not have to repay the investment if your business fails, however, you will have to be ready to give up some control and ownership of your business.
• Mezzanine financing-This is done by lenders who set up this debt tool by offering the business unsecured debt (no collateral is required). However, it is important to understand that the tradeoff is a high interest rate, (usually in the 20- 30 percent range). In addition, you must understand that the lender has the right to convert the debt into equity in the company, if the business owner defaults on payments. Despite the high interest rate, mezzanine financing often appeals to small business owners because it offers quick liquidity. And it should be noted that even though it can be converted to equity, the issuing bank usually does not want to be an equity holder.
• Hybrid financing-This is done when a business owner turns to a combination of debt and equity financing to fund their company. The question becomes: What is the proper combination? This is done by dividing your total debt amount by your total equity amount. Keep in mind that both lenders and investors, will want to see this number, to get an idea of how financially viable your business is. They will also use to see where their investment stands in case your business goes bankrupt, since debt holders get priority over equity-holders in recovering funds during bankruptcy.