Using Debt Financing to Increase Your Insurance Capital and Grow
February 23, 2023 •Oak Street Funding
There is unquestionably some wisdom in avoiding debt, particularly for individuals. One of the first financial lessons most people learn is to live within their means. Taking on more through debt financing than we can afford to repay can easily push us into a situation that spirals out of control. With that said, insurance capital is an important factor in the overall financial stability of an insurance company and necessary to continue company growth.
Most insurance professionals are financially conservative by nature, and their attitudes toward borrowing often spill over into their businesses. They avoid debt in their personal life and do their best to steer clear of it in their professional life as well.
Different for businesses
Debt plays different roles for individuals and businesses. When it comes to business borrowing, “debt” isn’t the most accurate term. A better choice is “leverage,” because that describes the role borrowing can play in your insurance agency. Essentially, when your agency leverages debt financing, you’re leveraging other people’s money to achieve a purpose that will increase your wealth or increase your insurance capital.
The idea of borrowing is so negative to many business owners, that they make a big mistake in an effort to avoid it. When they need extra insurance capital, instead of taking on temporary debt, they permanently give up part of their equity by assuming partners, known as equity financing. Equity financing gives someone else the opportunity to profit from the hard work you’ve already put into the business, and you’re taking on what Kevin O’Leary describes as “a permanent partner that will bother you for the rest of your business’ life.”
Debt financing and equity financing are two important sources of financing for businesses. Both options have their own advantages and disadvantages, and choosing between the two often depends on the specific needs and goals of a company.
Which is better for my company: debt financing or equity financing?
Debt financing and equity financing are two important sources of financing for businesses. At times it might make sense to use a combination of both options and each business must make that decision. There are several advantages and disadvantages of both to consider.
Advantages of Debt Financing:
- Fixed Repayment Amounts: With debt financing, businesses know exactly how much they need to repay each month, making it easier to budget and plan their finances.
- Lower Cost of Capital: Debt financing is often less expensive than equity financing, as the cost of borrowing is typically lower than the cost of selling equity.
- Tax Deductibility: Interest payments on debt financing are tax-deductible, which can help to reduce a company’s overall tax burden.
- Retention of Control: When a company takes on debt financing, it does not dilute its ownership or control, unlike equity financing where the ownership is shared with the investors.
Disadvantages of Debt Financing:
- Repayment Obligations: The obligation to repay debt financing is absolute and failure to repay can result in legal consequences and damage to the company's credit rating.
- Interest Payments: While debt financing may have a lower cost of capital than equity financing, it still requires the payment of interest, which can become a significant expense over time.
- Limited Flexibility: Once a company has taken on debt financing, it is committed to repaying the loan and can be limited in its ability to take on new debt or pursue new opportunities.
When compared to equity financing, debt financing offers a number of advantages and disadvantages. Equity financing involves the sale of ownership in a company, in the form of stock, to investors. In exchange for their investment, equity investors receive a share of the company’s profits.
Advantages of Equity Financing:
- No Repayment Obligations: Equity financing does not require repayment, as investors are not lending money but rather purchasing a share of the company.
- No Interest Payments: Since equity financing does not involve borrowing money, there are no interest payments required.
- Flexibility: Equity financing provides a company with the flexibility to use the funds as they see fit, without being restricted by the terms of a loan agreement.
Disadvantages of Equity Financing:
- Dilution of Ownership: When a company raises funds through equity financing, it is diluting its ownership, as it is selling a portion of the company to investors.
- No Guarantee of Return: Equity investors do not receive a guaranteed return on their investment, as they are taking on the risk that the company will not perform well and their investment will not appreciate in value.
Why do companies prefer debt financing over equity financing?
There is no single answer to whether debt financing or equity financing is "better" for a company, as the appropriate financing mix depends on the specific circumstances and goals of the company. The optimal financing mix will depend on a variety of factors, including the company's financial position, its risk profile, and its growth plans. Most important is there should be a specific purpose for your decision to obtain financing, whether that’s to buy upgraded technology, build a new office, or acquire another agency or book of business.
Which option is safer?
To say there is a safer option is difficult because it really depends on the reasons for debt financing. As mentioned as a disadvantage of debt financing, obligation to repay debt financing is absolute and failure to repay can result in legal consequences and damage to the company's credit rating. If a company takes on too much debt, it can become overleveraged and may struggle to service its debt obligations if its profits decline or interest rates rise. Too much debt can also increase the risk of financial distress, as the company may be at risk of defaulting on its loans if it is unable to make its debt payments.
Which option is more profitable?
It is not accurate to say that either debt financing or equity financing is inherently more profitable, however, when you maintain control and equity in your business using debt financing, you are not sharing your profits with investors or diluting your shares. Equity financing is generally considered to be more expensive for the company in the long run, as shareholders expect to earn a return on their investment, either through the appreciation of the company's value or through dividends. In addition, your debt payments are tax deductible and can help with your overall tax burden.
Debt financing drawbacks
As an insurance professional, you know that every reward carries corresponding risks, and the use of debt is no exception. The advantages of using debt to grow your agency are offset to some degree by several points. The biggest is that you’ll be expected to repay what you owe, even if something happens to your agency. In some cases, you’ll be expected to back your loan with a personal guarantee, so that if the lender can’t collect from your business, it can chase your personal assets. And, if the lender requires collateral, borrowing may place some of your business assets at risk. In addition, if you file bankruptcy, the lender will get first crack at any assets that remain.
Depending on the market, the lender, your agency’s financial health, and your own personal credit history, you may have to pay a higher-than-normal interest rate. The more you borrow, the higher that rate is likely to go.
Finally, if your agency becomes heavily dependent upon debt, it might be viewed as risky at some point in the future when you’re courting a buyer or partner.
The financing to support your growth
Once you’ve made the decision to expand and transform your insurance agency, you’ll probably need to invest some additional insurance capital in your business.
Where should you go? Often, agency owners turn to a familiar source: a bank officer. However, most traditional banks aren’t comfortable with the financial structure of insurance agencies. Most are geared to making loans to businesses that have tangible assets such as inventory, equipment, and real estate. Another option is loans that are guaranteed by the Small Business Administration, but SBA loans typically take a long time to process, may involve an overwhelming amount of paperwork, and have relatively small lending limits.
That’s why a growing number of insurance agency owners are turning to specialty lenders that are accustomed to working with the confines of the insurance industry. Such lenders understand how an agency like yours operates, and are familiar with the nature of your income streams, so they can approach the underwriting with realistic expectations and an appreciation for inherent risks.
Disclaimer: Please note, Oak Street Funding does not provide legal or tax advice. This blog is for informational purposes only. It is not a statement of fact or recommendation, does not constitute an offer for a loan, professional or legal or tax advice or legal opinion and should not be used as a substitute for obtaining valuation services or professional, legal or tax advice.