Introduction
Raising capital is one of the most critical aspects of starting or expanding a business. While there are various ways to secure funding, borrowing remains a common and effective strategy for many entrepreneurs. Whether through traditional bank loans, private lenders, or alternative financing methods, debt financing allows business owners to access the necessary funds without relinquishing ownership or control.
However, borrowing comes with both advantages and risks. While it can provide immediate access to capital with structured repayment terms, it also creates financial obligations that can impact cash flow and long-term business viability. Understanding the different types of borrowings, how lenders evaluate loan applications, and what collateral and guarantees might be required can help you make informed financial decisions.
This guide explores the various borrowing options available to businesses, the benefits and challenges associated with each, and how to navigate the loan application process effectively. Whether you’re a startup looking for initial funding or an established business seeking expansion capital, knowing how to leverage borrowings strategically can be a key factor in your financial success.
What are borrowings?
Borrowings are loan proceeds. When you take out a loan(s) to fund your business’s start-up costs or operating expenses, you are using debt (rather than equity) to finance your business. There are many forms and sources of borrowings. These include loans against the stock, equity, or assets of your business; loans from banks and private sources; credit card, home equity, and other consumer borrowing; and loans from you to your business. You may even be able to get a guaranteed loan through the Small Business Administration.
What are the advantages of using borrowings to finance your business?
Interest payments are generally tax deductible
The interest on business purpose loans is often deductible for federal income tax purposes.
Repayment schedule is predictable
When you take a loan to finance business expenses, your repayment schedule is generally set when you sign the loan documents (except in the case of a revolving line of credit). Payments are likely to be equal in amount and made at regular intervals. This will allow you to more easily work the loan payment into your operating budget.
Lender has no claim on future value of the business or future earnings
Unlike equity financing, debt financing does not require you to give up ownership or control of any part of your business. To the extent you continue to meet your monthly obligation, the lender has no claim on the assets or earnings of your business. However, if you default on a loan, any assets you use as collateral could be in jeopardy, including your business itself.
What are the disadvantages of using borrowings to finance your business?
Debt must be repaid
As with all loans, business borrowings must be repaid. Although you don’t give up equity in your business or control over management decisions, you will have to repay the money you borrow, plus interest, according to the terms of your loan agreement.
Loan agreement may restrict future borrowings
Lenders want to be assured that you can repay your debt. Thus, restrictive clauses may be included in your loan documentation that limit your future borrowing to a certain level. Lenders may use this tactic in an attempt to keep you from borrowing more than you can afford to repay.
Lenders often require collateral for loans
Although you don’t give up equity in your business when you borrow, you may be required to provide collateral. This collateral could be business equipment, inventory or other assets, stock, or just about anything. If you fail to repay the loan as agreed, you will likely forfeit your collateral. In addition, your loan documents may prevent you from selling or replacing the items you use as collateral without providing alternate collateral.
Lenders will often require personal guarantees from the principals of the company, especially in the case of a start-up business.
Banks
For better or worse, most people still go to the bank first when looking for a loan, whether it is for business or personal needs. Banks can be an excellent resource for your business financing needs, but they should generally not be the only source you consider.
How do you get a bank loan?
If you are interested in getting a bank loan, or any business loan for that matter, you will need to put together a formal loan request. Briefly, the purpose of the loan request package is to tell the lender how much money you need to borrow, what type of loan you want, how you will use the funds, what the repayment term will be, what the source of repayment will be, and what collateral and guarantees are available. You should back up this proposal with financial statements, balance sheets, income statements, cash flow statements, accounts payable and receivable reports, tax returns, and other pertinent information. Since your business plan should also contain all this information, you might just provide a copy of the plan with your loan request. Your request and the supporting documentation should be presented to the loan officer at the bank or institution of your choice. The loan officer will likely then have to present your request to a lending committee, which will make the final decision on your application.
How do banks evaluate a business for lending purposes?
Unlike investors, banks don’t care how great your idea is or how much growth potential your business has. Bankers want to know that you can repay the money you borrow and want to see stability, cash flow, and especially collateral. They will generally also evaluate the character and creditworthiness of your principals, because personal guarantees are often required. In addition, bankers want to see your personal capital invested in your business. After all, if you aren’t willing to take a chance on yourself, why would a bank do so?
What should you look for when choosing a bank?
The most important thing to look for in a bank is financial stability. If your lender is not financially sound, the chances of having your loan called due before the maturity date increase dramatically. Other factors to consider include aggressive lending policies, strong history of business lending, ability to meet your other financial needs (such as business checking and savings accounts, payroll, cash management, etc.), and referrals from others in the business community.
Other sources of loan funds
Banks are not the only source of loan funds for your business needs. You should be aware of your other options, especially if you are in need of funding for business start-up costs. Creative financing is often necessary in this situation. The following are some other ideas you might consider.
Private loans
Borrowed funds need not come from institutional sources. Individuals may be willing to lend money to your business as well. You might find friends or family members willing to lend money to your business, or you might discover a wealthy stranger with an interest in making your business work.
Credit cards, home equity loans, and other consumer loans
You might be able to fund many of your business expenses through everyday means, such as credit card borrowing, home equity loans, cash-out home mortgage refinancings, and the like. These loans are generally easier to obtain than formal business loans, and the dollar amounts may be adequate if your business venture is relatively simple. Keep in mind, however, that you are the borrower on these loans, not your business, so you will be personally responsible for repayment whether or not your business succeeds. In the case of home equity loans and mortgage refinancing, the loan is secured by your house. If you default on the loan, you could lose your home.
Loans from you to your business
Your business can borrow money from you as well. In this case, you are creating a debtor/creditor relationship between the business and yourself. You might get the money to fund such a loan by liquidating personal checking or savings accounts, stocks, and bonds, or by taking a loan against the cash value of your life insurance. Another possible source is your IRA or other retirement account, although there are restrictions on the use of these funds.
Types of secured loans
Banks and other lenders may be more willing to lend money to your business if you are able to provide collateral.
Loans against stock/equity
You might consider using stock (if your business is a corporation) or equity (if not) in your company as collateral for a loan. This way, the lender would actually become a part owner of your business if you fail to repay your loan as agreed. Because the value of your collateral is not fixed, the lender may require stock or equity currently worth more than the loan proceeds. For example, you might have to provide $1 million in stock or equity as collateral for a $500,000 loan.
Loans against assets
Your business assets can also be used as loan collateral. Assets that might be used include business equipment and machinery, product inventory, accounts receivable, and the like. Keep in mind that depreciation and market value may influence the amount you can borrow when you use assets as security.
Personal guarantees
As mentioned previously, many lenders require personal guarantees from business owners and/or officers. This means that if the business is unable to repay the loan, the lender has the right to go after the guarantors’ personal property. Giving a personal guarantee is a common business practice, but it can be risky. Make sure you understand what you’re getting yourself into. Consult your legal advisor before you make a personal guarantee.
Conclusion
Using borrowings to raise capital for your business can be a powerful tool when managed wisely. By securing the right type of financing and maintaining a solid repayment strategy, you can fund growth, manage cash flow, and seize new business opportunities. However, it’s essential to weigh the risks, particularly the potential impact on your personal assets, financial stability, and future borrowing capacity.
Before taking on debt, carefully assess your financing needs, repayment ability, and available collateral. Consider consulting financial advisors or legal professionals to ensure that you fully understand the terms of any loan agreement. Additionally, explore multiple lending sources—from traditional banks to private investors—to find the best fit for your business.
Ultimately, the key to successful borrowing lies in balancing risk with opportunity. By making informed, strategic decisions, you can use borrowed funds to strengthen and grow your business while maintaining long-term financial health.
Scarlet Oak Financial Services can be reached at 800.871.1219 or contact us here. Click here to sign up for our weekly newsletter with the latest economic news.
Source:
Broadridge Investor Communication Solutions, Inc. prepared this material for use by Scarlet Oak Financial Services.
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on individual circumstances. Scarlet Oak Financial Services provide these materials for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
