How Much Debt Can Your Business Handle?
In my book, Great CEOs Are Lazy, I talk about how most great business models rely on very low or even no capital requirements at all. Rather, they can grow based solely on their high margins and the cash they generate through their business.
But I recognize that not every business is fortunate enough to be in that position. There are times when you need to access capital beyond what your business can organically provide. One option is that you can bring on investors, but that brings a lot of complications and potentially a loss of control of your business.
Instead, let’s talk about what it looks like to take on debt to help grow your business–which is a topic I get asked about all the time by the CEOs of fast-growing companies. Many finance professors would suggest that you want a bit of debt in your business to maximize results.
Debt is a deep and complicated subject that I could write several books about. But for our purposes here, let’s talk about the basics and what it might mean to your business.
Level One: Supplier Debt
One of the forms of debt that many entrepreneurs overlook is your ability to treat your suppliers like a bank. Think about it: you are borrowing money from them in terms of the time between when you receive goods and when you pay for those goods. In some cases, that might be millions of dollars that you might be able to use elsewhere in your business for an extra 30 to 60 days versus cutting a check to your supplier. And there’s usually no cost to this form of debt–aside from the fact that you shouldn’t be risking a relationship with your vendor by abusing the terms of paying them what you owe them. But, if done correctly, managing this kind of debt could be the difference between having to go to a bank or not. If you have any issues with this approach, realize that your customers are using you as a bank as well.
Level Two: Bank Debt
If you need a loan, your first line of defense is usually a simple asset-based line or ABL. The idea is that you pledge certain assets in your business as collateral for borrowing money from a bank. A commercial lender might lend you 60% of the value of your accounts receivable balance, for example, and 50% of the cost of your inventory. The amount you borrow can then shift up or down based on the balance of your AR or your inventory.
Another common form of bank debt is structural debt where you can secure a loan based on your company’s earnings, often expressed as earnings before interest, taxes, depreciation, and amortization–or EBITDA for short. A commercial lender might lend you money based on a multiple of your earnings, usually two to three times EBITDA. If you make $1 million in earnings, for instance, you might be able to secure a loan for as high as $3 million–maybe even $4 million with an aggressive lender. Their debt is secured by the cash flow of the business so there will be ratios that you need to meet to keep them happy, in addition to paying the note down over time. You can have an ABL and structural debt.
But for all of these loans, you will need to pay interest. The rate you will pay will be based in part on your creditworthiness as well as what the current market rate is for LIBOR, or the London Interbank Offered Rate. It’s pretty typical to pay an extra 1% on top of LIBOR in terms of your loan–which might add up to about 4% interest these days.
Level Three: Mezzanine Debt
If your business needs more money than even what a commercial lender can provide, your next option would be to find what’s called a mezzanine lender, often a private equity investor or group of investors. These loans are not tied to any assets in your business, so they are “unsecured debt.” You can think of them as credit cards. But, just like with credit cards, these kinds of loans can get very expensive as they charge interest rates that might be 10% or higher. With mezzanine debt, you can add another 2 or more turns of debt onto your business, which is something that many private equity firms will do if they own your business.
While your business might need that extra bit of fuel to turbo-charge your growth or take advantage of a juicy opportunity, most CEOs will tell you that living with lots of expensive debt is an uncomfortable place to be since every nickel you make in earnings needs to go toward paying down that debt.
That’s why even these investors warn entrepreneurs to maximize whatever loans they can get from less expensive sources like banks before coming to them for mezzanine debt financing.
So, when it comes to deciding what kind of debt your business might need, think about how you can do more for less cost through your suppliers before going to the banks. Then, as a last resort, consider mezzanine debt–but also have a plan for how you can pay off those loans as quickly as you can.