Choosing the Right Debt for Your Small Business

Debt is a useful (and sometimes essential) tool in business. But applying the wrong debt to your company can be catastrophic. Taking on debt may feel scary or exciting, but understanding each type of debt can help you keep a level head when building your capital strategy.

Do you know what is the right kind of debt for your small business?

Here’s our recommendations on the best type of debt for each business’ situation.

Best Debt for Capital Expense: Term Loans

A special one-time loan that is fully amortized (like mortgages) so you’ll pay the same amount every month until they are fully repaid. This is the most traditional type of loan people think of.

Why use a term loan?

Term loans are almost always used to purchase equipment, real estate, vehicles, or build-out a new facility. The asset is used to collateralize the loan.

Pros of Term Loans:

• Low interest rates due to collateralization.

• Somewhat easy to secure.

Cons of Term Loans:

• Requires good credit.

• The collateralized asset can be repossessed if you stop paying the loan.

Know Before You Borrow:

Term loans are available at commercial banks, specialty asset financiers, and sometimes even at the equipment dealers where you buy the asset.

Best Debt for a Safety Net: Lines of Credit

A flexible borrowing option that allows businesses to draw funds as needed (up to a limit), paying interest only on the amount used. If you never draw the funds, you pay no interest! This makes lines of credit the perfect safety net.

Why use a Line of Credit?

Ideal for managing short-term cash flow gaps, low seasons, or unexpected costs.

Pros of Lines of Credit:

• Flexible and reusable capital.

• Lower interest rates than most alternative loans.

• Can be unsecured (no collateral), but will require a personal guarantee.

Cons of Lines of Credit:

• Strict qualification criteria (good credit and profitable financials required).

• Can be reduced or revoked if bank policies change.

• Usually requires a personal guarantee.

Know Before You Borrow:

Lines of credit need to be renewed every year or two. If your financial performance degrades or the bank becomes more risk averse, they may revoke your line.

One of our clients had a bad year during Covid-19, so their bank canceled the line and converted it to a term loan. This threw the company into a short-term cash crisis which we helped them navigate through until they found another lender.

Best Debt for Distressed Businesses: Merchant Cash Advance (MCA) Loans

A lump sum provided upfront in exchange for a portion of future credit card or cash sales. MCA loans are typically issued by online lenders with fast approval processes based only on bank account history, making their underwriting fast and easy.

Why use an MCA Loan?

Provides fast access to capital, especially for businesses with high daily sales volumes but weaker credit profiles or poor accounting.

Pros of an MCA Loan:

• Fast approval and funding (often within 24 hours).

• Repayment scales with sales.

• No collateral needed.

• May not require  a personal guarantee.

Cons of an MCA Loan:

• Extremely high effective interest rates (APR often 70–200%).

• Confusing deal terms which mask your true APR.

• Daily or weekly repayments which strain cash flow.

• Generally predatory loans.

Know Before You Borrow:

These loans are everywhere – you probably have received offers in your spam folder, or even from Paypal or American Express. Anyone advertising “fast funding” is probably an MCA lender.

MCA lenders that expresses interest as APR are more legitimate than those that charge fees, discount %, dollars per day, or other irregular measures that are not compliant fair lending laws.

Check out our video on calculating the cost of MCA loans.

Best Debt for Startups: Venture Capital Loans

Many venture capital firms offer debt vehicles designed for high-risk, unprofitable startups.

Why use a VC Loan?

These lenders understand startups won’t have strong balance sheets and use different metrics to measure risk – such as cash runway, venture capital backing, and revenue growth.

Pros of a VC Loan:

• Often the only type of debt available to startups.

• May include strategic guidance and networking benefits.

Cons of a VC Loan:

• Typically include warrants or other dilutive instruments.

• Rigorous due diligence the borrower often has to pay for.

• High interest rates compared to bank financing.

• Often tied to performance metrics and milestones.

Know Before You Borrow:

When seeking a VC loan, we tell our clients to ask their investors for referrals. They will point you toward the lenders they are comfortable partnering with.

The Cheapest Debt: Owner Financing

Business owners can lend their own company money, often by leveraging personal debt facilities such as HELOCs or stock margin loans.

Why use owner financing?

Owner financing is often the fastest and easiest cash.

Pros of Owner Financing

• Fast and easy.

• Provides interest income to related parties.

Cons of Owner Financing

• Owners often do not have personal financing available.

The Non-Conventional Debt: Customer Financing

Pre-sell services or charge deposits in advance of the customer’s use. This could be charging an annual fee for SaaS licenses, selling a product warranty, charging an up-front membership fee, or requiring a customer deposit.

Why use Customer Financing?

Customer financing is attained through sales, not through lender relationships. Companies with poor credit or strong sales processes can tap more easily attain this capital.

Pros of Customer Financing

• Fairly inexpensive, sometimes free capital.

• Automatically grows as you sell more.

• Can compliment your products and services (e.g. selling warranties).

Cons of Customer Financing

• Complicates the sales process, may lower close rates or increase CAC.

• Complicates accounting.

Know before you borrow:

One time, a business asked our help managing cash flow. It turns out they’d spent their customer deposits on management salaries and had no cash left to buy their raw materials. Their customers were complaining about late shipments, and the company had no cash to fulfill the orders.

If you use customer financing, be sure you are following strict budgeting and spend controls to avoid disappointing your clients.

The Right Financing for Your Business

The strategic position, risks, and goals of your business will define which form of debt is right for you. Before you commit your business to a debt agreement, collaborate with your CFO or financial advisor to make sure your capital plan aligns with your business needs.