Debt is often perceived negatively in a business context because it can impact a company’s financial performance, credit rating, stability, and ability to grow. Because of this, debt-free access to working capital is an appealing option for many business owners. 

In this article, we’ll look at equity financing and invoice factoring, two ways that business owners can increase their working capital without taking on the burden of additional debt.

The dangers of debt

According to the 2023 Small Business Credit Survey published by Fed Small Business, more than 90% of small businesses (those with fewer than 500 employees) experienced a financial challenge in 2023, and 37% applied for loans, lines of credit, or merchant cash advances. 

High-interest, punitive forms of debt financing such as merchant cash advances (MCAs) are almost never a good idea, but other types of debt financing such as loans and lines of credit (LOCs) can be a useful way to free up working capital.  

However, there are drawbacks to any type of debt. Even when debt is handled responsibly, it can be unexpectedly costly, with interest, fees, and penalties all eroding the bottom line. And there are other, less visible costs, too. Carrying debt can impact a company’s credit report, and for owners who are planning to sell their business, it can discourage potential buyers. 

There is also a risk of abusing the credit facility, which can negatively affect the company and the business owner directly. 

Corporate America is carrying a $13.7 trillion debt load, and almost half (44%) of U.S. small businesses have less than three months’ worth of cash on hand. Many companies struggle to manage debt, with one in every 100 U.S. businesses failing to meet their loan obligations 

“People get into business because they’re experts in the service they provide or the widgets they sell,” explained Gordon Farr, Executive Vice President, Sales and Marketing, of AR Funding. “They understand sales very well, so they focus on the revenue or sales number at the top of the P&L statement. But they aren’t always financial experts, so they don’t look at the deeper story the books tell.”

As an example of the risks of relying on debt to fund an expansion, Farr recounted the story of a client whose business provided IT services to the government. After securing a contract worth $200,000 per month, the business owner was able to secure a $250,000 line of credit (LOC) to fund payroll and growth. As the size of the contracts increased, the LOC increased, ultimately reaching $750,000. When the contracts abruptly ended, the owner was unable to service the debt. 

“If a business owner is disciplined and knows how to track cash flow, a line of credit can work for them. But for many small and medium-sized companies, that’s not the case,” said Farr. 

Equity financing

For business owners who want to minimize their exposure to debt or avoid it altogether, here are two options to consider. The first is equity financing. 

Equity financing helps businesses raise working capital by selling shares in the company. Those shares entitle the shareholders to an ownership stake in the company and a portion of the profits. Depending on the type of shares, shareholders may also have a say in how the company is run.

On the upside, equity financing is a debt-free way to free up capital, and if the business fails, the owner is not burdened with the need to repay the funds. On the downside, if the business succeeds, the owner must share the profits with the investors. 

Despite its debt-free advantages, just 6% of small business owners finance their companies with equity investment compared to 54% who relied on loans or LOCs. (1)

Invoice factoring

The other way to access working capital without going into debt is invoice factoring. The cash businesses receive through invoice factoring are not loans: they are technically advances. As a result, they have an improving effect on the company’s balance sheet. 

“When we purchase an invoice, it’s already a receivable on the company’s balance sheet,” Farr explained. “When we hand over the advance to the company, it’s earned revenue that they can use to fulfill future orders, pay overhead, or do anything else they need to.”

Because factoring does not involve loans, there are no restrictions on how the cash is used and no covenants that the business owner needs to follow. 

When to choose debt-free financing

Debt should be seen as one of many useful tools in a company’s financial toolbox. In some cases, a loan or line of credit may be the best way to free up working capital. In others, debt-free financing options may be a better choice. Here are some of the reasons a business owner may choose to prioritize debt-free sources of financing.

• Businesses that already carry debt. If the business has already taken out loans or LOCs and needs additional working capital, it’s a good idea to explore debt-free options. This is especially true if the source of debt is high-interest credit card debt or MCAs.  
• Businesses with less financial experience. Businesses that don’t have an experienced CFO managing the finances may want to avoid debt instruments because it’s easy to get into trouble when you don’t know how to manage and monitor the company’s debt load. 
• Businesses that want to improve their credit. If a company has misused debt in the past and needs to repair their credit profile, debt-free financing options can help to build a healthier balance sheet.
• Businesses that are planning to be acquired. For business owners that plan to sell their company, invoice factoring can help to reduce the debt load and demonstrate more robust financials. (Read this case study about a wholesale company that used factoring to improve the company’s prospects for an advantageous sale. 

Equity financing or invoice factoring?

If your business could benefit by reducing or eliminating debt, you may wish to explore options such as equity financing or invoice factoring. While both are debt-free options, they offer different advantages.

 

Manage debt wisely

Accessing the working capital you need to support and grow your business is crucial to your long-term success, but you may not need to go into more debt to get it. To learn more about how invoice factoring can help you achieve your business goals, contact an AR Funding factoring expert in your region.

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 1 Fed Small Business, 2020 Report on Employer Firms: Small Business Credit Survey.