Is Business Debt Bad?

Once you’ve decided your business is ready for funding and you know how you’re going to spend the money you’re looking for, you’ll need to decide how you want to be funded. There are two options—debt and equity. You can take out a loan (either from a bank, community lender, a family member or friend, or someone who uses a baseball bat to do their collections) or you can seek investment. Both options have their merits and drawbacks, and both have their place in the life of your business.

Let’s talk about debt today.

Debt

If you’re anything like me, you became familiar with the word ‘debt’ around the age of 18 when every credit card company in North America sent you solicitations. Or perhaps it was when you signed a few pieces of paper to pay for college and received a bill a few days after graduation for $50,000. Either way, debt has a nasty, negative reputation for most consumers. And rightfully so—but that’s a different book. For businesses, though, debt can be a great tool, if used properly and responsibly.

When you take out a loan to start or grow your business, you are taking a risk. The risk that you may not be able to produce enough cash flow to pay back the loan, is one you should consider for more than a moment or two. This is not something to enter into lightly. Let me tell you a story.

In my first position as a loan officer for an economic development organization, I met a very charismatic, talented, and driven entrepreneur. Let’s call her Gina. Gina was 32, a mother of five, and had been on some form of public assistance (EBT, housing assistance, WIC, etc.) her entire life. She found herself caught in the cycle of poverty and unable to escape working her 9-5 job. As any person with an entrepreneurial spirit does, Gina decided to take matters into her own hands and start her own company. I met with Gina multiple times a week for several weeks. When the time came to present Gina’s loan package/request to our loan committee, her $5,000 request (well below our average loan amount) was met with pushback from even the most lenient and risk-tolerant members of the board. They saw things I didn’t—things I couldn’t see as I was still wet behind the ears. I made the board a deal that I would meet with her regularly, I would make her success my own, and I would take on the challenge (at the wise age of 22) of helping this single mother of five change her life.

Trepidatious as they may have been, they gave her a shot and approved her loan so she could start her business.

Six months later, I was submitting her account to a collections agency. Before we took that action, however, she called me—the first phone call since we closed the loan. She told me that as hard as she was trying, she wasn’t getting where she needed to be. Worse yet, she told me she was choosing every month between making sure her kids had clothes and food or making the loan payment. As a human being, I couldn’t fault her for making sure her children were taken care of before a loan payment. Who could? What I learned, though, was how I could have prevented her from having to make the decision at all.

So badly I wanted her to be successful. I felt in my heart of hearts that she could make it work. Even without proof of success at that point, I felt she had what it took to start and run a successful business. The problem with “feeling” is feelings have very little space in the credit analysis and decision-making process. I’ve reviewed and made decisions on hundreds of loan requests since Gina’s, and I think of her every time I want to take a chance on someone whose numbers, past experience, and planning just don’t line up with what’s coming out of their mouth. I will never put someone in that position again.

Remember Gina as you go through the loan application process. Don’t put yourself behind the proverbial eight ball right out the gate. If you’re going to take on debt, make sure you understand everything expected of you and everything you’re receiving. First and foremost, understand if you can afford that payment every month until it’s paid off.

Outside of affordability, you need to be familiar with the covenants that exist in your loan agreement. Are you required to report your financial performance to your lender? Are you required to meet with your banker or loan officer on a regular basis? Do you have to make your loan payment out of a certain account? On what day? What collateral are you using to secure your loan? (We’ll get to this in a minute.) Do you have a normal, straight amortization or are you going to be required to make balloon payments at any time?

Let’s not get ahead of ourselves though. Before we read the loan documents, we first have to get approved for the loan. The loan process isn’t hard, but it is tedious. You’re going to be asked for document upon document upon document. Be prepared with two-to-three years of tax returns (both personal and your business), a personal financial statement, proof of residence, identification, proof of income and employment, and, of course, business financial statements such as your balance sheet, P&L, and statement of cash flows, and even a breakdown of your accounts receivable. If you’re a startup business, you’ll need to provide a well written business plan, cautiously optimistic (at best) financial projections for 24-36 months, and a list of active and potential customers, as well as vendors or suppliers you plan on using.

All told, gathering this data only takes a few hours, but can feel overwhelming when you’re in the middle of it.

Once you submit this documentation, along with the lender’s loan application and any application fee they may charge, you’re looking at a turnaround time of at least two weeks, and possibly as many as six, depending on the institution and their policies.

There are ways to strengthen your application. Some of them are actually chapter titles in this book. Know why you’re looking for financing, know you can afford it, and help the bank mitigate their risk. The most concrete way a bank can mitigate their risk on any loan is by having collateral. Whether that’s equipment, a vehicle, or even a financial instrument worth as much as the loan, collateral gives the bank something to fall back on in case you fail to pay them back, the business fails, or some other catastrophe keeps you from meeting your obligation to pay them back as agreed.

Tidrow Capital Group, LLC is a privately held business advisory firm that specializes in helping businesses strategize their funding needs and gain access to the capital they can use to grow with confidence.