Confessions of an Entrepreneur: Using Debt Wisely
July 1, 2020 | By Mark Zweig
I read a post on LinkedIn the other day from a popular, self-described “Leader/Sales Professional/Inspiring the World Through Personal Development and Entrepreneurship.”
In it, he told a story that was supposed to help readers understand that all debt is bad, and you shouldn’t buy anything until you have the cash in hand to pay for it.
Problem is, while this philosophy may work for the author, he has a one-person “company.”
Since the primary distinction of an entrepreneurial venture over something that is just a small business is the entrepreneurial venture has value the owner can extract upon exit, and a one-person business is unlikely to have much of any value that can be sold, I felt obligated to jump in on this topic and share my experiences.
As someone who has started, owned, run and sold several high-growth businesses, I have plenty of experience with debt. We have had as much as $18 or $19 million of it at our peak.
And yes—debt can be bad, especially when you use it to acquire non-income-producing assets that do nothing for you beyond increasing your overhead. It is also bad if you don’t have the income to pay off the debt.
That said, even with as much debt as we had, we never defaulted on any of it, nor failed to make any payments on time. And we could never have done what we did and achieved the successes we had without that debt capital.
Imagine being in the real estate development business or property management business and not being able to use debt. Some of the most profitable projects we ever did were ones where we financed most if not all of our investment in the property. If you can do that and then either sell the project at a profit or operate it on a positive cash flow basis while you pay down the debt and at the same time have an asset that is increasing in value, you have a home run.
Debt doesn’t work just for real estate businesses. It is also very helpful for a professional service business that has to perform work, bill clients and then collect their money, sometimes months later. Being able to finance that is crucial to your ability to hire the people you need and keep them on the payroll until they start paying for themselves.
Debt has its place — especially if you consider the alternatives are to either NOT grow the business or to use only equity capital to fuel growth.
Equity capital — which means selling a piece of your business to someone — is far from the panacea it is often painted to be. When you sell equity to someone, they are going to want to have a say in how the business is run (rightfully so!). If their ideas don’t match up with yours, you’ve got a problem. There will be conflict.
The entire business strategy and plan may have to change to accommodate the investor’s thinking — especially if getting them out means paying them back for their equity with cash that you have already deployed.
Equity can be very expensive capital.
If you accept the premise that business value is directly linked to the revenue it is able to generate, as the business grows so does the value. One of our businesses consistently generated a 50%-plus annual return on equity (not including owner salaries and benefits!) over a 13-year period. Someone who invested $15,000 had an asset worth $120,000 five or six years later. We had to pay that money back to them when they exited.
Compare that to the cost of debt. The last business line of credit we just renewed in one of our companies has a 4.75% interest rate. That is less than a tenth of what the annual cost of equity would have been.
Not to mention the fact that no one starts a business because they want to work for someone else and live their dream. And that is exactly what happens to so many entrepreneurs who get outside equity capital.
In extreme cases, selling that equity to return-driven investors can result in founders being fired from the very companies they created.
Entrepreneurs often seek out equity versus debt because in most cases, equity doesn’t have to be paid back if the business fails. But if the business succeeds you will pay dearly for that equity capital.
The bottom line is this. Many times (not always), debt is necessary and beneficial to the business. Business owners who refuse to take on any debt will probably either not be able to grow their business or have to bring in outside equity investors.
As a friend of mine said to me the other day, “While debt may have strings attached, equity has chains attached to it!”