Every entrepreneur needs money to get an idea off the ground, but securing funding can be time-consuming and stressful. Adding to the stress of finding a willing investor is the fact that many entrepreneurs are not very familiar with finance. The jargon can be confusing and the pros and cons of various types of financing may not be clear. To help you make sense of the options, we are starting a series of weekly “Finance Friday” blog posts to address important aspects of finance for entrepreneurs. In this first post, we will discuss the most common type of financing—debt—and the pros and cons associated with it. Next time we will take a look at equity.
In all of these posts, we would love to hear your thoughts and questions, so please contribute to the discussion!
Informal and Small-scale Debt
For many entrepreneurs, the first sources of funding that come to mind may be family and friends. This close network can be very supportive of early-stage business ideas – they all want you to succeed, and you may be able to secure some small loans from them. The advantages of this are obvious – approaching them is comfortable, they will probably not be overly demanding, and they already know you, so the process for securing the money is minimal.
But such informal sources of debt also have their problems. Expectations for repayment are often not made clear, the amount of money available is normally minimal, and if the business does not work out, failure to repay can have serious consequences for important relationships.
Even if such informal debt works at an early stage, it is often not enough to get a business very far. Scaling a business only using such financing is out of the question. The same is true of microfinance. While microfinance can be an excellent source of funding at the very start of a business, microfinance institutions seldom provide enough capital to expand and grow your business significantly, and the group-lending model (essentially a form of social collateral) that dominates microfinance is not as appropriate for larger-scale investment.
Institutional Lending
Once family, friends, and microfinance have been exhausted as sources of capital, banks are generally the next common source for larger loans, but loans can also be provided by private investors, governments, or other corporations. At this level of financing, the main benefit of debt is that you don’t have to give up an ownership stake in your company to receive funding (as we will cover next time with equity). Just pay back the loan with interest and you are done. Depending on the cash flow you will be generating, you may be able to obtain a loan with an initial grace period, which would allow you to delay payments until you are generating more revenue (but grace period longer than 12 months are rare).
The main disadvantage of debt financing is that collateral is often required. Lenders want to know that if you can’t pay back your loan, you have some assets they can possess and sell to reduce their loss. This fact means that debt is often not an appropriate way for some young companies to fund themselves. Especially for companies in IT or mobile/web application development, which may not have any significant physical assets to speak of, loans will be harder to secure (unless you take the risk of using your home or vehicle as collateral). After all, a bank cannot take your coding and sell it like they could take a car, a piece of land, or a building. Debt will also be harder to secure if you are not generating revenue already. Lenders want to know that your product will actually sell so that you have money to pay back the loan.
So if your company is too big for loans from family and friends and too small to secure a larger loan from a bank, the next source of funding, equity, may be more appropriate for you. We will discuss that topic next week.
Until then, hopefully we can discuss debt a bit more. What challenges have you faced in trying to secure loans from family, friends, banks, or other sources? Have you come across any solutions that have made the process easier or more effective?
What is your experience – and thoughts on how you have or wish to finance your start-up?
Filed under: Business Tagged: debt, entrepreneurship, finance, Financing a business, Growth Africa, GrowthHub, loans, microfinance 
