Oftentimes, a business is in need of additional capital but does not want to surrender control of management decisions.
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Outside investors and private equity firms may be able to provide plenty of capital, but they also usually end up taking a substantial role in the leadership of the company. Debt financing allows young entrepreneurs to amass additional resources and retain control over operating decisions.
Many times pre-revenue start-ups will be unable to secure a loan from a commercial bank because they lack the collateral necessary to take a debt position.
Types of debt which require the pledging of an asset are called secured loans. From a lender's perspective, senior debt financing serves as the least risky form of secured lending; in the repayment schedule it takes priority over all other forms of financing.
In addition, the lenders of senior debt must be repaid before any other lenders receive payment. This quality of senior debt classifies it as unsubordinated debt.
Senior debt is often amortized, or repaid, in a period of five to seven years in monthly installments. The interest rate usually increases as the period of amortization increases. This means it is in the company's best interest to pay down the debt as soon as possible unless it is able to obtain a return on assets higher than the interest rate of the loan — which is, for the most part, unlikely.
To qualify for senior debt financing, a company must have some form of collateral assets and a strong cash flow record that suggests the company will be able to repay the loan.
The interest rate of senior debt, which can range anywhere from half a percentage point under prime, to five points over prime, is often based on the quality of the company's assets and historical cash flow performance. Essentially, the lender will set a higher interest rate if there is a greater perceived risk of a company being unable to repay the loan.
In addition to the interest rate being subject to a strong balance sheet and a good record of cash flows, the lender will often set certain financial performance terms for a company. For example, a bank may impose a bottom line of cash flow; if the company falls below that mark, it may default on the loan. To prepare for a default, a bank will often set the limit on the loan amount under the total value of the company's liquid or near-liquid assets. This will ensure the company's ability to re-pay the full value of the debt, even if it breaks the terms of the loan.
Understanding the distinguishing factors among the different types of debt is an important part of being aware of the financing options available to you as an entrepreneur.