Debt is dangerous. When used smartly, debt is a vital building block for a fast-growing business. Before taking on debt, be sure you can predict the future cash flow available to pay it off. Further protect yourself by balancing debt with equity. And finally, manage your personal and business risk by looking at the big picture—what would happen if the business could not provide enough cash to pay the loan back? All loans have to be paid back in cash.
1. Debt is dangerous. When used smartly, debt is a vital building block for a fast-growing business. Before taking on debt, be sure you can predict the future cash flow available to pay it off. Further protect yourself by balancing debt with equity. And finally, manage your personal and business risk by looking at the big picture—what would happen if the business could not provide enough cash to pay the loan back?
2. All loans have to be paid back in cash. “Convertible” loans actually allow a successful business to convert the borrowed amount to an equal value of stock in the company.
3. Banks are my only option. Wealthy individuals, called angel investors, are probably the most prolific lenders for small businesses. Corporate finance companies, private investment funds, even credit card processing companies are also making the kinds of loans that banks can’t or won’t. But make sure the terms are at least as good as the best traditional loan.
4. I can’t afford the payments. Loans that require interest-only payments and “negative amortization loans” are two examples of low-payment loans. They will be more expensive in the long run, but the smaller payments may be a good fit for a rapidly growing business. Traditional loans can be made more affordable by negotiating a longer payback period or an adjustable rate that starts low and then “floats” as rates change.
5. As long as I make my payments, I’m ok. Larger loans from institutional lenders (like banks or corporate finance companies) will include specific loan terms, like keeping a certain amount of cash on hand or meeting strict profitability targets. Breaking just one “covenant” can force immediate repayment of the entire loan amount.
6. Debt is expensive. Actually, interest rates are low, and when the tax deduction for interest expense is factored in, debt is pretty cheap. Borrow only when the rate of interest is lower than the rate of return.
7. One size fits all. Just as a house is best financed with a 30-year mortgage, most business purchases should be matched with a loan of a size and term that roughly matches the size and term of what is being purchased.
8. All loans require collateral. Credit cards are the obvious exception, but there are others. Often called “cash flow loans,” these rely simply on a business’s ability to make payments. Lenders want to see a solid business plan. These loans carry higher interest rates.
9. I don’t have any collateral. Many lenders are able to use certificates of deposit, stock accounts, cars, boats and other personal assets (including your home, of course). And don’t forget that the business assets you most need to purchase often make their own collateral. Most equipment vendors, for example, will be able to recommend leasing companies for their products.
10. Banks only make loans when I don’t really need the money. Getting a loan is only difficult for the unprepared. So do your homework before talking to a banker. A great business plan, clean financial statements and detailed financial forecasts will carry a lot of weight.