Financing – Is it really worth it?

When I was in business school, I was under the delusion that entrepreneurs used other people’s money to get rich. Now I would argue that this is the exception as opposed to the norm. When most of my friends and I started our businesses, we had very little financing. For me, it isn’t because I lacked potential sources of financing (e.g. credit cards). Rather it is because of a simple truth that seems to escape a large portion of the population. You are expected to pay loans back! Whether it is a legal requirement or a moral obligation, most lenders expect you to repay your debt at some point.

For me, entrepreneurship is about freedom and flexibility. The ability to do whatever you want, whenever you want to do it is awesome. Obviously this freedom and flexibility also gives you the freedom not to have any customers and the flexibility not to make any money, but you have to take the good with the bad. The point being debt inhibits this freedom and flexibility. I have a client that is essentially being forced to work for the bank. Their business was fully leveraged. Now they are in default with the bank. The bank wants their money back. My client doesn’t have it. My client is helping the bank collect as much cash as possible before they close their doors. We hope the bank won’t enforce the personal guarantees. Although my client still “owns” the “business”, it doesn’t feel very entrepreneurial to me.

Don’t get me wrong, I understand that not every business has the luxury of avoiding outside financing. And sure, MAYBE you could accelerate your ten year plan to five years. But ultimately you must evaluate whether debt is really worth it to you (e.g. personal guarantees, debt covenants, interest costs). In my opinion, there are only a few reasons to incur debt. These include:

1. Working Capital: Financing used to help manage the Cash Conversion Cycle (or Cash-to-Cash Cycle). This is financing the purchase of a widget today for the ability to sell it at a later date (hopefully for a profit). The proceeds from these sales should be used to pay off the corresponding debt.
2. Income Producing Furniture, Equipment, Building, and Land: Essentially anything you NEED in your business to make money. Income-producing means it will either increase revenue or decrease cost. The income generated from these purchases should be used to pay down the debt in a reasonable amount of time.
3. Income Producing Acquisitions: Identifying situations where 1+1=3. When done properly, acquisitions should earn additional income through elimination of redundant headcount/overhead, cross-selling product/services, etc. Again, the income benefit generated from the acquisition should be used to pay down the debt in a reasonable amount of time.

All other costs else should be funded by equity. This can be equity from your personal net worth, retained earnings, friends, family, or outside investors.

I realize that a lot of entrepreneurs will disagree with my opinions (especially highly leveraged ones). But when credit markets tighten, businesses that practice these fundamentals will ultimately have the upper hand. Banks are still lending new money to companies that adhere to these practices. If your business is highly leveraged you are likely in trouble. A key to sustainability is to avoid getting yourself into that position to begin with.