What is debt financing?

Introduction

Debt financing is a method of financing whereby a company borrows money without giving up any ownership of the company. Debt financing often comes with strict undertakings, in addition to having to pay the principal and interest on specified dates. Failure to meet these undertakings can result in severe consequences (including the loan becoming immediately due and payable, and any security becoming enforceable). Furthermore, entering into a lot of debt increases the company’s future cost of borrowing money and it adds risk for the company.

Secured and Unsecured Loans

Debt financing includes both secured and unsecured loans. Security involves a form of collateral as an assurance the loan will be repaid. If the debtor defaults on the loan, that collateral is forfeited to satisfy payment of the debt.

Most lenders will ask for some sort of security on a loan. Few, if any, will lend you money based on your name or idea alone. In an unsecured loan, your credit reputation is the only security the lender will receive. Accordingly you may be able to obtain a personal loan for several thousand dollars, or more, if you have a good relationship with the bank, but these are usually short-term loans with very high rates of interest.

Most lenders are very conservative and are unlikely to provide an unsecured loan unless you have done a lot of business with them in the past and have performed above expectations. Even if you do have this type of relationship with a lender, you may still be asked to post collateral on a loan, due to economic conditions or your present financial condition.

Repayment Terms

Most debt will be subject to a repayment period. There are three types of repayment terms:

1. Short-term loans are typically paid back within six to 18 months.
2. Intermediate-term loans are usually paid back within three years.
3. Long-term loans are paid back from the cash flow of the business over five years or less.

Conclusion

When lending or borrowing money, make sure you enter into a Loan Agreement. A well drafted Loan Agreement will set out the relationship between the lender and the borrower, explain how and when principal and interest is to be paid, contain detailed representations, warranties and covenants from the borrower in favour of the lender, and set out a list of events of default and the consequences of them. This will help avoid future disputes.

If you require a Loan Agreement or have been provided with one and it contains provisions which you are unsure about, please get in touch with us and one of our specialised finance lawyers will be able to assist.