Advantages and Disadvantages of Debt Financing | Capstone Partners (2024)

Raising Debt Capital: Key Considerations for Business Owners

Funding business’ operations often demands a significant amount of outside capital, especially if the company plans to expand operations in the near-term. Securing funds from third-party capital providers can expedite a company’s growth trajectory. Prior to describing how to raise capital, it is imperative to understand the different types of capital that are available. There are two primary types of capital raising for businesses: equity financing and debt financing. Equity financing requires selling either a minority or majority stake of a business to an investor, often a private equity firm. Debt financing is loaned money that must be paid back over an agreed schedule, for both principal and interest rate payments. Businesses that have yet to secure outside funding typically begin with debt capital, and as such, this article focuses on the debt financing process.

There are several nuances of debt financing to consider, including the type of collateral required to support the loan. Most loans are structured as secured facilities, meaning they are backed by some form of asset. In the case of a liquidation of the business, these loans are repaid in full before unsecured debt holders and shareholders. Outlined below are the primary advantages and disadvantages of debt financing which should be taken into consideration when determining what is right for your business.

Advantages of Debt Financing

  • Lender has no control over the business’ operation.
  • Prevents ownership dilution.
  • Interest paid on debt is tax-deductible in most situations.
  • Offers flexible alternatives for collateral and repayment options.

Disadvantages of Debt Financing

  • Financial covenants on lending agreements may limit certain actions of borrowers.
  • Greater debt-to-equity may increase the businesses’ financial risk.
  • Business owners may be required to personally guarantee the debt.
  • Assets could be seized as a result of payment default.

Common Motivations for Securing Debt Capital

Securing debt capital is a strategic and financial decision that businesses often consider for multiple reasons. Understanding the common types of actions to help your business capitalize on new opportunities is paramount in navigating the following:

  1. Acquisitions – Debt capital can be used to finance the purchase of businesses for your inorganic growth strategy. Acquisitions represent a common reason for securing debt financing.
  2. Growth Initiatives – Debt capital can be used to finance the purchase of expensive equipment or incremental space needed to grow the business, while retaining equity and maximizing business owners’ potential return from the investment.
  3. Debt Refinancing – Debt capital can be used to refinance outstanding debt at a lower rate to save on interest expense or to recalibrate the payment schedule.
  4. Personal Liquidity – Debt capital can be used to pay a dividend or other discretionary payment to owners/shareholders.

Typical Capital Financing Flow Begins with Debt, then Equity

The normal sequence of capital financing involves a structured progression from senior secured debt to subordinated debt, and ultimately to equity capital. This sequential transition is crucial for businesses to balance between debt leverage and equity ownership, and to minimize interest payments.

Capital Financing Sequence

Advantages and Disadvantages of Debt Financing | Capstone Partners (2)

Source: Capstone Partners

Key Considerations for Business Owners Looking to Raise Capital

Securing debt financing can be a stressful process that includes the organization of financial documents and requires diligence information to be shared with potential lenders, speaking with potential lenders, and negotiating terms sheets. Capstone Partners’ Debt Advisory Group works closely with clients to optimize their debt structures and secure the best long-term institutional partners for the business. The Group also leverages the talents and expertise of our industry specialists to ensure that the financing strategy and positioning results in maximum credit market receptivity. Business owners should evaluate their companies before engaging banking services in order to manage debt and mitigate associated risks to ensure long-term financial stability. Several key considerations for business owners surrounding debt financing are outlined below.

  • Loan Types — There are several loan types for business owners to consider when acquiring debt. Senior Bank Debt is usually backed by assets and represents the most secure form of debt capital, providing the borrower with the lowest interest rates as it also poses the least amount of risk for the lender. Junior Debt is secured by a secondary position on assets or cash, providing an easier access to capital. Alternately, Unitranche Debt is a blend of both Senior and Subordinated Debt. This instrument typically utilizes a single lender and streamlines the debt execution process.
  • Lender Types — The lender pool for businesses seeking debt capital can include both large public institutions and private lenders. Borrowers should consider their financial situation, creditworthiness, and urgency when choosing a lender type. Traditional banks offer stability, but private lenders may provide options when traditional avenues are unavailable. The choice is dependent on the borrower’s specific needs and circ*mstances, as well as current market conditions.
  • Financial Requirements — Payments are typically repaid over three to five years. With senior debt offering either a ramped schedule with a balloon payment at maturity (5%, 7.5%, 10%, 12.5%, 15%) or a lower percent payment and an excess cashflow (ECF) sweep provision. For the lender, calculating debt capacity, or the potential risk of a loan, is paramount in deciding terms for a loan. A few key ratios are used to understand the total debt capacity of the borrower:
    • Excess Cash Flow (ECF) — The equation starts with EBITDA and subtracts cash taxes, capital expenditures, cash interest paid, principal repayment, and the change in net working capital (NWC).
    • Total Debt/EBITDA — Over the course of a loan, lenders want to see an inverse relationship in debt to EBITDA, with debt falling and EBITDA rising. However, to safeguard against risk, a maximum acceptable ratio is usually negotiated. If exceeded, the borrower could be required to pay back the full loan amount.
    • The Fixed Charge Coverage Ratio (FCCR) — This ratio subtracts capital expenditures and cash taxes from the annual EBITDA, which is then divided by the annual principal and interest payments. A FCCR below 1.0x indicates a company cannot make its debt payments. Conversely, a ratio above 1.0x demonstrates that a company can pay all outstanding debt payments with a cushion. The standard ratio for lending is 1.50x although, in favorable markets, some lenders will accept 1.25x. In down markets, most lenders will seek a FCCR of 1.50x or higher.
  • Risk Mitigation — Knowing why more debt needs to be taken on, and having a plan once a loan is secured, can greatly increase the client’s ability to make full use of the capital. If it seems like an increase in debt or cyclicality would stretch cash flows too thin, reevaluate. In addition, efficient capital deployment can minimize the risk of loan payment defaults and bankruptcy.

Debt Capital Transaction Process

A debt capital transaction is typically completed within 10–12 weeks, depending on the availability and quality of information, access to sponsor and management, number of lenders marketed to, and legal resources applied. The process can be divided into four phases: preparing to market, marketing, solicitation, and diligence/closing.

Capstone’s Tailored Debt Solutions Simplifies Transaction Process

Advantages and Disadvantages of Debt Financing | Capstone Partners (3)

Source: Capstone Partners

When to Engage Debt Capital Advisory Services

Capstone’s Debt Advisory Group offers diversified, robust capital solutions in the debt capital markets, assisting clients with securing debt capital for acquisitions, scaling organic growth, and refinancings. Clients face many specific challenges while navigating volatile market conditions, with increasingly sophisticated debt financing services. Some of these special/unique circ*mstances include:

  • A borrower seeks higher debt capacity/leverage point, and the capital need goes beyond what a bank relationship can provide.
  • A traditional collateral-oriented bank loan structure does not work for a borrower.
  • The borrower is in a complex industry or situation that will not be financeable by a bank.
  • A borrower’s EBITDA has declined due to various reasons (supply chain, recession, internal expansion, etc.) likely leading to a potential covenant default.
  • An owner of a private business seeks to diversify his/her personal net worth via a “dividend recap” while aligning with a capital partner that can add value .
  • A borrower is considering a sale of all (or a portion of) the business and wants to identify potential financing sources to help mitigate financing risks once in market.
  • A borrower just went through an M&A process which did not result in a sale but still has the desire to obtain some liquidity for its shareholders by pivoting to a dividend recap to “bridge” the shareholders liquidity needs until the sale process is revisited at a later date.

Capstone Partners Case Study: AVT Simulation Raises Senior Debt Financing

In 2023, Capstone Partners advised AVT Simulation—a recognized leader in the —on the closing of a $25 million senior credit facility with a commercial bank, the proceeds of which were used to fund the development and delivery of Helicopter Training Simulators to the U.S. military.

The company is a 100% founder-owned small business that provides professional engineering services and training solutions for both military and civilian applications, with products and services including engineering consulting, simulation and training solutions, software engineering, visual system integration, database development, gaming technology and content.

The senior credit facility will fund a recently awarded long-term subcontract for the development and delivery of helicopter training Simulators for the U.S. Army. Learn more about AVT at www.avtsim.com.

“Capstone’s extensive experience greatly assisted us in our capital raise and achieved a more than ideal outcome. Speed in preparation, modelled structure, and close could not have been realized without Capstone and their outstanding guidance,” said Robert Abascal, Founder and Chief Strategy Officer of AVT Simulation.

About Capstone Partners Debt Capital Advisory Group

Our Debt Advisory Group has developed established relationships with over 400 institutional lenders across the credit universe, including commercial banks, finance companies, credit opportunity funds, business development companies (BDCs), insurance companies, private debt funds, and family offices. The firm’s deep credit experience and entrenched relationships allow Capstone to deliver tailored debt solutions and provide real-time market intelligence on current market terms, lending trends, and structural alternatives. Typical transaction parameters involve companies with $10-$70 million in EBITDA and capital raises in excess of $30 million.

Capstone Partners offers a full suite of services to help business owners achieve their goals. If you are considering a capital raise to support the goals of your company and would like professional guidance on finding an investor to help meet those goals, please contact us.

Advantages and Disadvantages of Debt Financing | Capstone Partners (2024)

FAQs

What are the advantages and disadvantages of debt financing? ›

Pros of debt financing include immediate access to capital, interest payments may be tax-deductible, no dilution of ownership. Cons of debt financing include the obligation to repay with interest, potential for financial strain, risk of default.

What is a disadvantage for firms using debt financing? ›

The main disadvantage of debt financing is that interest must be paid to lenders, which means that the amount paid will exceed the amount borrowed.

Which of the following are advantages of debt financing? ›

Advantages of Debt Financing

Prevents ownership dilution. Interest paid on debt is tax-deductible in most situations. Offers flexible alternatives for collateral and repayment options.

What are two disadvantages of debt financing Quizlet? ›

Debt Financing- borrowing money the company has a legal obligation to pay. Advantage- Loan interest is tax deductible Disadvantage- more expensive, high risk, requires collateral.

What are the disadvantages of debt funds? ›

While debt funds are generally considered safer than equity funds, they are not entirely risk-free. Factors like interest rate risk, credit risk, and liquidity risk can affect the performance of debt funds.

What are the advantages and disadvantages of a debt management plan? ›

Pros and Cons of Using a Debt Management Plan
  • You only need to make one monthly payment. ...
  • You may be able to secure lower interest rates. ...
  • You'll likely save a lot of money. ...
  • You Should See Your Credit Score Increase Over Time. ...
  • You are required to close your credit card accounts.

Why do small firms use debt financing? ›

The major advantage of debt financing over equity is that you retain full ownership of your business. Plus, interest payments are deductible business expenses, and you'll build your credit. Because most debt entails scheduled payments, it's easy to plan around.

What is the major disadvantage of debt financing is the inability? ›

The major disadvantage of debt financing is the inability to deduct interest expenses for income tax purposes. Equity is the owner's investment in the businesses. Selling a firm's accounts receivables to a financial institution at a discount is called countertrading.

What are the advantages and disadvantages of debt factoring? ›

Advantages of debt factoring
  • Improves cash flow. ...
  • Fast access to capital. ...
  • Flexible qualification requirements. ...
  • Saves time and resources. ...
  • Reduces profit and can be expensive. ...
  • Not suitable for all businesses. ...
  • Loss of control over payment collection. ...
  • Could be responsible for debt if customers don't pay.
Oct 10, 2023

Why should you use debt financing? ›

The advantages of debt financing are numerous. First, the lender has no control over your business. Once you pay the loan back, your relationship with the financier ends. Next, the interest you pay is tax-deductible.1 Finally, it is easy to forecast expenses because loan payments do not fluctuate.

Why is debt financing cheaper than equity? ›

Since Debt is almost always cheaper than Equity, Debt is almost always the answer. Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders). The risk and potential returns of Debt are both lower.

What is a major advantage of debt financing interest expense? ›

The statement is true that the major benefit of debt financing is the tax deductibility of interest expense. Interest expense is tax deductible, which means interest expense is deducted from the net income, which in turn reduces the tax liability. Thus, it is an advantage of debt financing.

What is a disadvantage of debt financing? ›

The disadvantages of debt financing include the potential for personal liability, higher interest rates, and the need to collateralize the loan. Debt financing is a popular method of raising capital for businesses of all sizes.

What are 2 advantages of using debt financing compared to equity financing? ›

The main advantage of debt finance is the fact that you retain control of the business and don't lose any equity in the company. This means that you won't need to worry about being sidelined or having decisions taken out of your hands. Another key benefit is the fact that it's time-limited.

What is one of the main disadvantages of debt factoring over other forms of finance? ›

PUTS BUSINESSES IN TEMPORARY DEBT

Whilst debt factoring provides instant working capital, it also leads to short-term debt. Whilst this should be paid off as soon as the customer pays the invoice, it can lead to bad debt if there are problems in between.

What are the advantages and disadvantages of finance? ›

The advantages and disadvantages of the different sources of finance
Source of financeOwners capital
Advantagesquick and convenient doesn't require borrowing money no interest payments to make
Disadvantagesthe owner might not have enough savings or may need the cash for personal use once the money is gone, it's gone

What is the advantage and disadvantage of debt settlement? ›

Debt settlement pros and cons
ProsCons
Might be able to settle for less than what you oweCreditors might not be willing to negotiate
Pay off debt soonerCould come with fees
Stop calls from collection agenciesCould hurt your credit
Could help you avoid bankruptcyDebt written off might be taxable

What are the advantages and disadvantages of using short term debt as a source of financing? ›

What Are the Pros and Cons of Applying for Short Term Business Loans?
  • Pro: You'll Receive Your Loan Quickly. ...
  • Con: These Loans Come With High-Interest Rates. ...
  • Pro: The Loan Application Process Is Simple. ...
  • Con: Frequent Payments Are Required. ...
  • Pro: Easy to Qualify For. ...
  • Con: There's the Potential for Significant Debt.
Apr 11, 2024

What are the advantages and disadvantages of borrowing money? ›

Borrowing money allows you to support aspects of your business which you may not be able to afford. Yet even if you do have the good fortune of possessing sufficient capital, parting with your savings could cause issues later in your business' development and limit your ability to build a reputable credit rating.

Top Articles
Latest Posts
Article information

Author: Ray Christiansen

Last Updated:

Views: 6508

Rating: 4.9 / 5 (49 voted)

Reviews: 88% of readers found this page helpful

Author information

Name: Ray Christiansen

Birthday: 1998-05-04

Address: Apt. 814 34339 Sauer Islands, Hirtheville, GA 02446-8771

Phone: +337636892828

Job: Lead Hospitality Designer

Hobby: Urban exploration, Tai chi, Lockpicking, Fashion, Gunsmithing, Pottery, Geocaching

Introduction: My name is Ray Christiansen, I am a fair, good, cute, gentle, vast, glamorous, excited person who loves writing and wants to share my knowledge and understanding with you.