Purchasing a home, a car or using a credit card are all forms of debt financing. When business owners need money to operate their business day-to-day or to make large purchases, they may need to obtain some financing for the business.
External financing may be needed if sources of internal financing—like personal funds the business owner can use or funds from family and friends—are not available. Even if family members lend you money for your business, they must charge the minimum IRS interest rate in order to avoid the gift tax.
Long-term debt is debt that matures in more than one year and is often treated differently than the short-term debt. Longer-term debt usually requires a slightly higher interest rate than shorter-term debt. However, a company has a longer amount of time to repay the principal with interest.
Even though the repayment on long-term debt is more structured and comes with a greater legal obligation than equity, equity is often more expensive over time. Successful companies have to continue to offer owners a return on equity in perpetuity, whereas long-term debt eventually matures.
The greatest advantage to long-term debt is that it allows for expansion without immediate revenue obligations. Startups or cash-strapped companies can use debt to strike while the iron is hot if current reserves are insufficient.
Debt may be difficult to obtain in the early stages of a business because you don’t yet have a clear track record.