Question

What is debt funding?

Answer 1

Debt funding is money a business (or individual) borrows that must be repaid over time, usually with interest. Unlike equity, debt does not give the lender ownership in the business — it creates an obligation to make scheduled payments (interest and ultimately return the principal).

How it works (basic):
- Lender provides capital up front.
- Borrower pays interest (periodically) and repays principal by a maturity date (or in installments).
- Loan documents define interest rate, term, repayment schedule, collateral, and covenants (performance rules).

Common forms:
- Bank term loans
- Lines of credit
- Bonds or notes (public or private debt)
- Convertible debt (can convert to equity under conditions)
- Mezzanine debt (subordinated, often with equity kickers)
- Trade credit and asset-backed financing (receivables, inventory, equipment loans)
- Venture debt (for growth-stage startups)

Key terms to know:
- Principal: amount borrowed
- Interest rate: cost of borrowing (fixed or variable)
- Maturity: when principal is due
- Covenants: lender-required financial or operational conditions
- Collateral/security: assets pledged against the loan
- Amortization: schedule of principal repayments

Advantages:
- Owners keep equity and control
- Interest is often tax-deductible (jurisdiction-dependent)
- Predictable payments enable planning
- Can be cheaper than equity if creditworthy

Disadvantages / risks:
- Regular payment obligations increase cash-flow pressure
- Default risk can lead to penalties, seizure of collateral, or bankruptcy
- Excessive debt raises financial risk and can hurt credit ratings
- Covenants can restrict business flexibility

When it’s used:
- To finance growth, capital expenditures, working capital, acquisitions, or refinance existing debt
- Appropriate when the business has predictable cash flows or assets to secure borrowing

Simple example:
Borrow $100,000 at 6% interest for 3 years with interest paid annually and principal repaid at maturity. Annual interest = $100,000 × 6% = $6,000. At the end of year 3 you repay the $100,000 principal.

Choosing between debt and equity depends on cost, control preferences, cash-flow predictability, and risk tolerance. For significant financing decisions, consult a financial advisor or lender to compare terms and covenants.