Is Loan Financing the best for Startups?

In setting up a business, various forms of resources are necessary to make the idea a successful one.

Businesses require money, time, and human capital for growth. Unlike an established business with traction, startups are like the way they sound – starting from the scratch.

This business process requires financing from different sources; both internal and external to get it started. Internal financing includes support from family and friends, personal savings, and other informal giving whereas, external financing can come from crowd funding, angel investors, startup incubator, venture capitalists, grants and donations.

There are two forms of financing a startup; equity financing and debt financing. Equity financing is a form of financing where investors support the business by buying shares in the business. Capital raised by equity is not repayable because investors purchased a portion of ownership in the business. Equity financing is usually sourced from crowd funding, venture capitalists, angel investors and stock market.

Debt financing entails borrowing money and then repaying it over time with interest and getting a loan is the most typical way to finance debt. Other ways include selling bills, bonds etc. A loan is any financial arrangement in which one or more individuals, companies, or other entities lend money to another individual, company, or other entity. The recipient incurs a debt and is often responsible for both paying interest on the debt until it is repaid as well as the principal amount borrowed. Equity financing may be less risky than debt financing because there is no loan to repay or collateral at stake. Debt also calls for recurring payments, which might hinder a startup cash flow and ability to expand.

Startup business loans are any sort of loan used to start a new firm; they are not a particular kind of loan. Funding for companies that have already begun operations but are still in the very beginning stages might also be included in startup loans. Loan financing is one option that can be beneficial for some companies, but it is not appropriate for every business. Bank loans are not usually considered in startup financing as an option due to low or no credit history and collateral to hedge for the startup business. However, there are other types of loan financing to support startups. These loans include Business line of credit, online term loans and other microloans.

Pros

1. Capital – Obtaining loans is a smart approach to get the money needed for both the starting and ongoing costs of running the firm. If an entrepreneur is just starting out and doesn’t have enough money, loan financing is a viable choice.
2. Credit score of startup – Business credit is an advantage to a business if it can fulfill its loan obligation as a startup. Having a good credit history can make way for future financing.
3. Ownership and control – Loan financing is a technique to keep control of the business since not every business owner would want to sell their idea to a venture capitalist or angel investor. Shareholders are given control of a corporation through equity funding, and they make management decisions. As investors must have a role in how the business is run, this can easily lead to the business departing from the original objectives the owner had in mind.
4. Choice of funds utilization – Unlike with equity financing, a startup entrepreneur can choose how to spend money raised for the company at a pace that would ensure its survival.

Cons

1. No collateral – Banks are cautious to provide loans for young businesses because of a variety of factors, such as a startup’s lack of collateral and experience managing finances. Those with substantial management experience rarely get the chance too.
2. Interest repayment – Interest rates and repayment penalties that are part of the loan terms are very costly for a startup. Furthermore, because these payments are stretched out over a lengthy time, it will take longer for the business to stabilize, which has an impact on the startup’s financial records.
3. Assets are at risk because the business runs the risk of turning over their possessions to the bank in the event of a payment default.

All things considered, startups have access to a variety of funding sources, albeit occasionally it varies depending on the stage of the business. For efficient decision-making, it is also crucial to consider the pros and cons of loans against equity in light of corporate objectives.

Emmanuel Otori has over 10 years of experience working with 100 start-ups and SMEs across Nigeria. He has worked on the Growth and Employment (GEM) Project of the World Bank, GiZ, Consulted for businesses at the Abuja Enterprise Agency, Novustack, Splitspot and NITDA. He is the Chief Executive Officer at Abuja Data School.