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Debt Finance

A debt is an obligation owed by one party (the debtor) to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. A debt is created when a creditor agrees to lend a sum of assets to a debtor. Debt is usually granted with expected repayment; in modern society, in most cases, this includes repayment of the original sum, plus interest. Debt finance is a means of using anticipated future purchasing power in the present before it has actually been earned. Some companies and corporations use debt as a part of their overall corporate finance strategy.

Debt finance includes both secured loans and unsecured loans. Security involves a form of collateral as an assurance the loan will be repaid. If the debtor defaults on the loan, that collateral is forfeited to satisfy payment of the debt. Most lenders will ask for some sort of security on a loan. Few, if any, will lend you money based on your name or idea alone. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid.

The most common source of debt finance for startups often isn’t a commercial lending institution, but family and friends. When borrowing money from your relatives or friends, have your attorney draw up legal papers dictating the terms of the loan. Why? Because too many entrepreneurs borrow money from family and friends on an informal basis. The terms of the loan have been verbalized but not written down in a contract.

Debt finance can be long-term or short-term. Long-term debt financing usually involves a business’ need to buy the basic necessities, such as facilities and major assets, while short-term debt financing includes debt securities with shorter redemption periods and is used to provide necessities such as inventory and/or payroll. (see equity finance)

Tax deductions are huge attraction for debt financing. In most cases, the principal and interest payments on a business loan are classified as business expenses, and thus can be deducted from your business income taxes. It helps to think of the government as a “partner” in your business, with a 30% ownership stake (or whatever your business tax rate is). If you can cut the government out of the equation, then it’s beneficial to your business.

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