Most founders think of getting funding as a critical part of building a company. If there isn’t enough cash flow from revenues, outside funding is necessary to capitalize on growth opportunities.
But often this is a process of “finding funding” with very little time dedicated to matching up the uses with the funding type.
Which brings us to everyone’s favorite conversation … let’s talk about debt.
The basic debt structure hasn’t changed in millennia. Money is provided from a lender to be paid back over time with interest. The problem being solved is the lack of cash flow to build a revenue-generating asset.
But it’s important to understand the types of debt you may run across. A debt that doesn’t fit the situation can kill a business.
Here are some levers that affect how debt is structured and how to look at different costs.
Every lender requires some kind of asset or property that they can claim if the loan isn’t paid back. This collateral requirement drives many of the other terms for a loan.
The lender is trying to avoid the risk of not being paid back. This is a lever used to mitigate some of that risk.
For example, a bank reduces payback risk by looking for hard assets (equipment, real estate, inventory, personal assets) and a long track record of historically profitable operations.
Specialty lenders can loan against very specific assets based on their knowledge of the risk.
Some examples include:
- Purchase order financing – a loan against a contract for future revenue (asset)
- Inventory financing- a loan against inventory value (asset)
- Equipment financing – a loan against the value of the equipment (asset)
- Subscription financing – a loan against signed subscriptions (asset)
We see a lot of innovation in this area, especially in loaning against future revenue, subscription agreements, and point-of-sale trends. Most of the newer sources of financing are becoming possible because transparent access to data allows lenders to look at the value and risk of assets in real-time.
The lender is trying to avoid unknown risks. If they don’t know how to get paid back if the loan goes bad, then it isn’t likely they will make the loan.
- The less collateral, the higher the cost of the loan.
- The larger the loan compared to the collateral, the higher the cost. Ex: a loan of $50k against $100k in collateral is less costly than the same loan amount against $50k worth of collateral.
- Some collateral (real estate, cash) is more valuable than other collateral (cash flow, personal guarantees) depending on what the lender’s specialty is.
Timing of payments
Terms in a loan that change the timing and amount of payments also directly affect the cost and usefulness of the loan.
- Payment cadence – Are payments weekly, monthly, annually? Is the first payment due right away, in a few months, or is it expected in a “balloon payment” at the end?
- Payment amount – Principal and interest? Interest-only? Variable based on some metric?
- Payoff length – How many weeks, months, years until it is paid in full?
Of course, lower payments help with cash flow, but in general, the longer it takes to pay the debt, the more interest will accrue and the higher the cost.
It’s worth mentioning that transaction costs—underwriting (process cost), research, validation, legal, fund transfer, monitoring, loan management, etc.—affect this as well. Sometimes these costs are upfront, sometimes they are just “baked in” to the overall loan.
That’s why it’s important to not just consider the timing, but also consider the intended use of the loan. Does the timing of the loan match how you use the funds?
The goal of finance, especially for small businesses, is to maximize cash flow while creating assets that generate value (typically, more profitable revenue).
If there isn’t enough cash flow to purchase assets needed, outside cash is needed. Sometimes, there is enough profitability, but the timing doesn’t line up with immediate needs.
The trick is to match long-term needs with long-term financing and short-term needs with short-term financing. This is where a lot of companies get hurt.
If the need is to find the cash to pay for inventory because the customer won’t pay you for 30 days, that’s a classic short-term cash gap. You need cash to buy inventory, the customer will pay for it (hopefully at a big profit), and you will pay back the lender (with some upside for them).
If the need is to buy a building, you probably expect that asset to provide value for years. The financing for that can be long-term. This provides more cash along the way through lower payments to add to the profits of your business. A one-year loan wouldn’t help much with cash flow.
Equity is an extreme example of long-term financing. Using equity to pay for short-term needs is the most expensive money you can get, with the investor typically expecting 10X or more back.
Be sure you are solving a problem with the right tool. There are no “evil” financial tools, but there are some real mismatches that can be costly.
Many times advisors try to use one metric to compare funding tools. This can be a good data point, but it isn’t always helpful. The focus should be on how well the financing solves the problem.
I’ll use a couple of non-business examples to illustrate (ignoring transaction costs and any “cash on hand” and any other outside variables).
Let’s say you are buying a house for $200,000.
You are buying a long-term asset and most likely need long-term funding. You may not be able to buy the house you need with a credit card. You may not be able to pay the house off in 5 years because the payments would be more than you could handle. That’s what a mortgage was designed for: long-term financing.
And these days, the interest rate is low because the government can “insure” the loan for the lender, and the house is easy collateral.
- 5-year loan at 6% – monthly payments would be $3,867
- 30-year loan at 6% – monthly payments would be $1,199
The 30-year is far better from a monthly cash flow standpoint while still being able to use the same underlying asset.
Same interest rate, but let’s look at the overall cost.
- 5-year loan at 6%: total payments add up to about 1.16X of the original amount
- 30-year loan at 6%: total payments add up to about 2.16X
The 5-year loan is far better from an overall cost standpoint. So which is better? It depends on what you need.
Now, let’s say you had an unexpected car repair that cost $600.
- Credit card at 17% for 3 months – $223 per month
- An uncle loans the money to you at 4% payable over 2 years – $28 per month
The “uncle” loan may bring more stress at a family gathering, but it’s far better from a monthly cash flow standpoint.
Same interest rate, but let’s look at the overall cost.
- Credit card at 17%: total interest payments are $18.50
- “Uncle” loan at 4%: total interest payments are $27.43
Even though the credit card charges more than 4X the interest rate than your uncle, your uncle charged 50% more in actual interest.
So which is better? It depends on what you need. If you can’t pay the credit card off, you need the more expensive loan that happens to have a lower interest rate.
Good and Bad Debt
The highest and best use for debt is when it can be used to acquire an asset (cash flow, machine, process, etc.) that continues to add value to your company. But making sure you are using the right tool for the job is the tricky part.
We’d be happy to help you match up the right tool (debt source, terms) with the right use (timing, assets, and cost)—let’s talk.