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Every day, we talk to entrepreneurs who are excited about growing their companies, but unsure if taking out a loan is the right decision for their business. As entrepreneurs and former investors ourselves, we understand the right path is not always obvious. In this two-part series, we’ll provide a simplified framework for how to think about raising the necessary capital to grow your company.
In this first post, we’ll provide more information on debt financing and a three-part framework for how to determine whether a loan is the appropriate tool to accelerate your business’ growth. In our next post, we’ll dive deeper and outline some of the common ways to borrow money and talk through the pros and cons of each.
In assessing whether or not debt financing is right for your business, we like to walk our customers through three questions.
1. Should your business borrow money, or is equity investment more appropriate?
If you don’t have sufficient personal savings or profits to fund your business growth plans, you have two options to find the capital you need. The first is to raise debt financing and another is to bring in an outside equity investor. There’s a time and a place for both approaches and it is important that you understand which makes the most sense for you and your business.
To help you narrow it down, here are the pros and cons of each option:
- Retain full ownership of your company
- Interest rate/cost of debt is known up front and debt payments are predictable
- You build a credit history of repayment –– making it easier to borrow in the future
- Quick, online applications for alternative lenders
- Business needs to be able to make consistent payments (monthly or more frequently)
- If the investment fails, the borrower must still repay
- Many lenders require a personal guarantee from business owners
- Investor will only benefit if business is successful
- Investor can be a strategic partner to help grow your business
- Investors may be willing to invest without operating history or profitability
- Give up a portion of company ownership with the investor
- Investor may require some control over decisions
- Investor will participate in the value created by the business
- Evaluation process can be extensive
If you’re thinking about borrowing, your business should have a good sense for how likely you will be able to repay the loan. This means having clarity on future revenue and profitability, as well as the expected return the additional debt capital could help create. If your future finances are unclear, then you should think about borrowing less or potentially considering equity as a way to raise the capital you need to grow.
For new companies or startups without much operating history, taking on an equity investor may be the better and more available option.
2. Can your business support debt?
Assuming you feel borrowing is a better option for your business, the next step is determining whether or not your company is in a position to take on debt. As mentioned above, lenders are going to expect consistent repayment of their money with interest. As a result, many lenders will look at your operations to make sure that your business is creating profits that meet or exceed those payments.
Additionally, you want to make sure you can support the loan payments because missing a monthly payment on a loan or credit card is a serious issue and can give rise to high fees and rates. Late payments also become a part of your business’s credit history and can hurt your ability to borrow in the future.
Lenders are trying to assess if your existing or future profits will enable you to repay the debt.
A good place to start is by getting a clear understanding of how much money your business makes each year. How much do you think you will need to borrow to invest in your growth, and what will that money cost you in terms of interest and fees? What do you think this money could help you achieve in terms of business growth and additional profit?
While these questions are important for you and your business, they are also the same questions that a lender, like Bond Street, will need answered in order to be comfortable with a lender relationship. In general, lenders are trying to assess if your existing or future profits will enable you to repay the debt over a specific time period.
3. Will your investments create value above the cost of debt?
You’re confident that borrowing money is the right approach, and that your company can support the debt repayments. The final step before moving forward is ensuring that the actual project you have planned is appropriate for the debt you have in mind.
Like anything else, borrowing money has a price. As with most investments, it makes little sense to pay that price unless you are confident you will create a larger amount of value from the investment. For that reason, debt isn’t a good idea if it’s for things that are nice-to-haves, but don’t necessarily help increase the value of your business. A different office paint color or higher salaries may be beneficial, but it is doubtful that they will improve the value of the business substantially.
Debt isn’t a good idea if it’s for things that are nice-to-haves, but don’t necessarily help increase the value of your business.
By contrast, borrowing money to fund projects with a clear-cut return (either by increasing revenue or decreasing costs) over a finite period of time is often a wise use of borrowed funds. Take Joe Coffee, a NYC-based coffee chain, as an example. The company used a $200,000 loan to fund a new location, purchase new equipment and hire new staff. This new location has allowed them to serve more customers and is already showing strong financial performance that will quickly exceed the ongoing cost of their loan.
If you have any questions or concerns, please leave them in the comments section below. Also, be sure to check out our next post about the different options for borrowing money.
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