Even though debt commonly has negative connotations, it is one of the most common financing routes for businesses, small and large. Right from startups whose owners ask family and friends to help them out with contributions to large corporations raising huge amounts of money through debt instruments and bank loans, debt can be a very useful and powerful tool to propel businesses to higher profitability. A quick look at why and how debt can be useful or not for your e-commerce startup:
Advantages of Using Debt
Enable retention of control of ownership of the business: Taking on debt has an obligation to repay the principal amount and the interest as per the schedule contracted. As long as you fulfill your obligations, the lender cannot interfere in your business. Also, unlike other forms of financing like venture capital, the financier cannot have any say in the way you conduct your business operations. This is the reason why, despite the high interest rate, most startups prefer to take on debt in the initial stages rather than part with some portion of the ownership.
Ability to claim tax deductions: Even though on the face of it many loans from banks or other financial institutions seem to carry a high rate of interest, in real terms, the cost of the money is not so high. You can claim deductions for the repayment of both the principal and the accrued interest from your income, thus effectively lowering the tax payment that you would have been liable to make otherwise. The higher the tax bracket you are in, the more attractive debt becomes.
Relatively quicker access to funds: Swiping your credit card or getting a personal loan is one of the quickest and easiest ways of accessing money for your business. Raising money through debt is a relatively faster process than most other methods. As an e-commerce business owner, you can approach your family and friends or even private money lenders and get the funds into your business account in a matter of days while making a public issue to raise equity capital or pitching for funds from venture capitalists can take months of preparation.
Disadvantages of Using Debt
A legal obligation to repay: When you borrow money to run your business, you are automatically obligated to repay the money along with the interest as per the terms of the contract executed with the lender. In case of default or late payment, the lender is entitled to charge fees and penalties as per the contract. If you are unable to repay the debt, the lender can move the court for recovery of the dues. This may involve liquidation of any assets that you may have pledged as collateral or even the entire business. However, if the debt is unsecured, the lender gets paid among the last and just before the owners out of the proceeds of the business liquidation.
Relatively high rates of interest: The rate of interest that you will be charged depends on multiple factors. The lender will quote a rate of interest that is a product of the risk evaluation conducted regarding your ability to repay. Startups are typically charged more since they do not have any track record of sales and profits. E-commerce businesses are also normally charged more since the environment is extremely dynamic and normally there are very little assets that the business owner can offer as collateral security. The absence of a track record, stable cash flow, and the lack of collateral assets are the prime reasons why the conventional banking system remains reluctant to lend to e-commerce startups. The rate of interest quoted by private lenders also depends significantly on your personal credit score. The relative lack of sources of debt is the principal reason why e-commerce startup owners turn to credit cards to meet business expenses despite the high rates of interest and other penal charges and fees. If you have accumulated too much debt, you can go in for a debt consolidation loan from a reputed online lender that will make debt management easier.
Impacts negatively on your credit score: Since in the initial stages of your e-commerce venture, you will not be able to put a proper valuation on the business, there will be very little interest by angel investors or private equity funds. With every loan you take, your credit score is hit negatively and successive loans become more difficult to get and attract a higher rate of interest. The more you take on debt, the riskier your business profile becomes and the interest rate zooms to compensate for it.
No certainty regarding cash generation to service the loan repayment: Even if the loan taken by you is vital for the purchase of an important asset of the business, it is impossible to be certain that the asset will generate adequate cash to enable you to repay the loan as per the agreed-upon schedule. Due to the very high rate of obsolescence of physical assets in the e-commerce industry, lenders are also not too keen to accept the assets as collateral and insist on other assets that have better value retention.
When to Use Debt to Finance Your Startup
Normally, the repayment of the debt begins shortly after you take the loan unless there is a moratorium. This makes it imperative that your business starts to generate enough cash to make the repayments possible. If you take on debt to buy equipment, it may be difficult to see the cash being generated immediately, however, if you are buying supplies or raw materials, a short-enough sales cycle may well generate a positive cash flow for the loan to be serviced.
Conclusion
When you are just starting out with your e-commerce venture, using debt to grow is perhaps the only funding route available despite its cost. However, as your business grows, you will be able to leverage better on debt because of the tax benefits. Overleveraging debt though is not a good idea as a sudden business downturn can make survival difficult.
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