Chapter 4

Knowing When to Use Debt to Finance Your Business

In This Chapter

Checking out how debt works

Recognizing when debt is a good option

Exploring your lender options

Wrangling some cash from the government

When discussing the concept of debt in today's economy, a very serious and unfortunate misconception needs to be clarified. That is, contrary to popular belief, the term debt isn't a four-letter word. Although the excesses of the housing debt binge have been well documented since the mortgage meltdown that began in 2007, that crash and the rash of foreclosures that followed highlighted how dangerous debt is — when used inappropriately.

If you remember one concept from this chapter, it should be this: Debt is most appropriately used when an asset is available to support the eventual repayment of the debt. Whether the asset is tangible (such as equipment used in a manufacturing process), paper based (such as a trade accounts receivable where a valid claim is present against a third party), or centered on the ability to reliably predict a positive cash-flow stream, the business must have a clearly identifiable asset that can be validated by an independent third party.

This chapter explores the pros and cons of debt, providing an overview of its key attributes and characteristics.

Understanding the Basics of Debt Capital

Debt-based capital is money contributed to the business in the form of a loan. It represents a liability or obligation to a business because it's generally governed by set repayment terms as provided by the party extending credit. The loan document is likely to include a claim against specific assets.

As an example, suppose a bank lends $2 million to a company to purchase additional production equipment. The bank establishes the terms and conditions of the debt agreement, including the interest rate (for instance, 8 percent), repayment term (say, 60 months), the periodic payment schedule, collateral required, and other elements of the agreement. The company must adhere to these terms and conditions or run the risk of default.

But debt isn't limited to just loans, leases, notes payable, and/or other similar agreements. Countless other sources of debt are used by a company to support daily operations. One example is to use payment terms (for example, due in 30 days) provided by vendors when purchasing products or services. This situation creates an account payable. Businesses also ask customers to provide advances or deposits against future purchases. These payments are a liability for a company. The liability is removed when the business provides the product or service (the purchase is complete).

Debt is best evaluated by understanding its two primary and critical characteristics: maturity and security.

Debt maturity

Debt maturity refers to the length of time the debt instrument has until the maturity date, which is the date the debt becomes due and payable. For example, in the case of trade accounts payable, vendors commonly extend credit terms of 30 days to their customers, which means payment is due within 30 days of receipt of the product or service.

Any debt instrument requiring payment within one year or less is classified as current (short-term) in the balance sheet. Logic then dictates that long-term debt is any obligation with a payment due beyond one year. For example, mortgage loans provided by banks for real estate purchases are often structured over a 30-year period. Hence, the portion of the debt due past the first year is considered long term in nature. A balance sheet displays the current portion and the long-term portion of a debt separately.

Debt security

Debt security refers to the type of asset the debt is supported by or secured with. If a bank lends $2 million to support the expansion of a manufacturing facility, the bank takes a “secured position” in the assets acquired with the $2 million loan. That is, the bank issues a public notice (generally through the issuance of a Uniform Commercial Code [UCC] document) that it has lent money to the manufacturing company and that it has a first right to the equipment financed in the case of a future default. Default occurs when a borrower misses an interest payment, a principal payment, or both.

Understanding secured debt

This security provides the bank with additional comfort that if the company can't cover its debt service obligations, a tangible asset can be retrieved and liquidated to cover some or all of the outstanding obligation. Other forms of security also include intangible assets (such as a patent or rights to intellectual property), inventory, trade accounts receivable, real estate, and future cash-flow streams (for example, a future annuity payment stream that guarantees X dollars to be paid each year).

You may assume, logically, that most organizations that provide credit to businesses prefer to be in a secured status to reduce the risks. However, for the majority of a company's transactions related to the periodic purchases of goods and services, this arrangement is logistically almost impossible due to the sheer volume of transactions being executed on a daily basis (for example, filing paperwork with the state on a per-transaction basis to note a secured position is incredibly inefficient and would overwhelm the system).

Secured creditors, often banks, are usually the ones focused on a company's infrequent or nonrecurring transactions. They tend to be associated with formal credit extension agreements (such as a lease or equipment loan), which are both relatively large from a dollars-committed standpoint and cover longer periods of time. Because the dollar amounts committed are large (and thus the risk is higher) and these transactions are less frequent, the secured creditors are more than willing to prepare and file the necessary paperwork to “secure” their position with the asset they've loaned money against.

Considering unsecured debt

In general, the majority of creditors actually turn out to be unsecured. This type of creditor tends to be the mass of vendors that provide basic goods and services to a company for general operating requirements. Examples of these vendors are professional service firms, utility and telecommunication companies, material suppliers, and general office services. Unsecured creditors obviously take on more risk in that a specific company asset isn't pledged as collateral to support the repayment of the obligation. This risk is mitigated by the fact that unsecured creditors tend to extend credit with shorter repayment terms (for instance, the invoice is due on net 30-day terms) and in lower dollar amounts. In addition, if unsecured creditors are concerned about getting paid, then they may use other strategies including requiring the company to make a deposit or a prepayment.

Other debt attributes

Beyond the maturity and security elements of debt are a number of additional attributes. Debt capital may involve the following distinctions and arrangements:

• Personal guarantees: A party outside the company guarantees the repayment of a debt, similar to the way a cosigner on a debt instrument works. In smaller companies, an owner or partner may personally guarantee company debt.
• Priority creditors: Certain creditors to a business may maintain a priority status due to the type of obligation present, such as payroll taxes withheld for the IRS, which by law overrides almost all other liabilities.
• Subordination agreements: A creditor may specifically take a secondary position to a secured lender. This is similar to what takes place when a homeowner takes out a second mortgage on a home.
• Default provisions: In the event of a loan default, set provisions indicate what the remedies of the parties involved are. For example, an acceleration clause may state that in the event of default, the entire balance on the loan immediately becomes due.
• Lending agreement covenants: The business must perform at a certain level to avoid triggering a default. A loan document may require the company to meet certain financial ratio numbers, such as a specific debt-to-equity ratio (for more on financial ratios, see Book IV, Chapter 6).

Before you structure and execute any type of loan, lease, note payable, and/or set terms and conditions with a creditor, consult an attorney to make sure that you clearly understand the agreement and the risks present. Consulting with an attorney helps you protect your company's business interests.

Determining When Debt Is Most Appropriate

For almost any debt-based need, some type of lender is usually available in the market. At one end of the spectrum are traditional banks and credit unions, which tend to be the most conservative lenders but also provide some of the best rates. On the other end of the spectrum are investment funds that specialize in providing high-risk loans, but of course loans from these sources tend to carry the highest rates. And in between are a slew of lenders that all have a unique niche in the market, depending on the credit risks, and that carry interest rates appropriately matched to the associated risks.

Businesses often secure capital from more than one source on a periodic basis. For instance, risk-based capital (in the form of equity) may be secured to develop a new product and support the initial launch into the marketplace, whereas debt-based capital may be secured to support an increase in inventory and to carry trade accounts receivable as customers purchase the products.

Not only are both forms of capital appropriate for a company's needs, but also the lenders may be more willing to step forward and provide the necessary capital — knowing that another partner has made a commitment. The “herd” mentality holds true for capital sources because they view the opportunity in a more positive light (by assuming a higher degree of success) if they know that the right amount and types of capital have been secured.

Debt-based lenders, similar to equity sources, tend to look for a common set of characteristics when extending credit. That list of characteristics differs from the factors considered by equity investors. The following sections describe the three primary characteristics.

When you can offer security or collateral

The business seeking a loan must offer primary and secondary sources of security or collateral (for example, a pledged asset or personal guarantee). If the amount of loan required is in excess of the collateral or security being pledged, then securing a loan will be very difficult (unless additional collateral is pledged).

The best scenario for securing a loan is a company that's highly profitable, has sound collateral, and offers a strong secondary repayment source. Of course, you may ask why a company in this situation would need to take on debt. The answer is that a company may want to use debt appropriately to enhance economic returns and results (because when all factors are considered, debt may be cheaper than equity).

When business is stable

Lenders want to get involved in stable business environments. The company must have been in business for an extended period of time, have a proven track record (a history of generating earnings and increasing sales), and have a solid management team at the helm. A proven track record certainly helps expand the number of funding sources available and can help secure lower rates.

If the lending sources in any way, shape, or form become concerned with the credibility of the management team and/or stability of the business operation, then chances are good that the lending source will pass on extending a loan. The last thing any lender wants to do is provide a loan and then, 90 days later, see the loan go into default and require collection actions.

When you have financial strength

Debt-capital sources are generally more conservative in nature than equity sources. Their goal is to ensure that the debt can be repaid, while generating an adequate return. Therefore, the company's ability to maintain solid financial returns and strong ratios is more important than its likelihood of doubling in size. Again, the same concept applies with financial strength as with business stability. The stronger the financial condition, the lower the interest rates. The weaker the financial condition, the higher the interest rates. For more on ratios that measure financial condition, check out Book IV, Chapter 6.

Some businesses, even if adequate collateral is available to secure the loan and no business credibility issues are present, may be just too financially “stressed” to extend a loan. In this situation, a lender may evaluate the company's ability to survive financially through turbulent times (lower sales, loss of key employees). If the lender becomes your last chance at survival, then it generally loses interest unless alternative financial resources can be secured to prop up the business.

Using Loans, Leases, and Other Sources of Debt

After you conclude that your business meets the security, stability, and financial strength requirements for appropriately using debt-based capital (discussed in “Determining When Debt Is Most Appropriate”), you can turn your attention to evaluating the different sources of debt and when each is used in a business.

No matter what source you choose, always qualify the capital source. You don't want to waste your time pursuing a loan that has no chance of being funded.

Borrowing from banks

Looking to secure capital from banks in the form of loans is one of the most tried and proven sources of capital. The old (and possibly outdated) image of a business looking to grow and in need of a loan to expand, hire new employees, and increase sales and profitability has always been a mantra of the banks. Sorry to spoil the party, but due to the criteria they use to underwrite the loan, banks aren't ideally suited to handle a good portion of business loan needs in today's economy.

When a bank or any type of lender refers to underwriting a loan, it means performing due diligence. It's the same process used by private capital sources when they consider providing additional debt or equity financing for a business. The lender undertakes a detailed review of the loan applicant's financial and business information to ensure that the borrower is creditworthy.

Mulling over lending criteria

Banks provide an important source of debt-based capital to businesses. Here are five key criteria a business must meet before a bank considers providing a loan:

• Positive earnings: In most cases, a company must generate positive cash flow or earnings to secure a loan. Banks are cash-flow lenders, which means that for any type of debt they offer, business cash flows must be adequate to repay the debt. So if a company has historical losses or is forecasting losses in the future, strike one.
• Sound collateral: Banks lend against assets to protect their loans. So every business looking to secure a bank loan needs to have sound collateral available (to repay the loan in case the business can't). Generally, banks like to lend against the most liquid assets, such as trade accounts receivable. They tend to be more cautious when asked to accept collateral such as inventory (which can become obsolete quickly) and equipment (which will depreciate in value and is expensive to liquidate if needed). So a bank's preference is to lend primarily against trade receivables and, if needed, then offer reduced loans or lending facilities against higher risk assets such as inventory. If you don't have quality collateral or the right collateral, strike two.
• Solid financial performance: The strength of a company's balance sheet is just as important as positive earnings when requesting a loan. When a business has excessive leverage (too much debt compared to too little equity), its business risks increase and a bank's interest decreases. So if your business is too leveraged, strike three.
• Secondary repayment: For most smaller- to medium-sized businesses (the vast majority operating in America), banks generally look for a secondary source of repayment to ensure that the debt gets paid. Or in other words, if cash flow isn't adequate and the collateral (if liquidated) doesn't cover the debt obligation, the bank needs to turn to another source of repayment to cover the debt. This secondary source generally falls back on the personal assets of the company's owners, which may range from real estate to personal savings to retirement accounts to other business interests owned. If no secondary repayment sources are available, strike four.

  A personal guarantee (or PG) pretty much means what it implies. That is, if your business can't repay a loan, then the lender will pursue the assets of the individual who signed the PG to ensure that full payment is received. Needless to say, PGs should be executed with the utmost caution and understanding, but at the same time, keep this important concept in mind: If you elect not to execute a PG, then the bank views your reluctance as a sign that you, the owner or founder, don't have faith in the business. So why would a bank lend money if the owners aren't willing to stand behind the company (even if all the other criteria are met)?

• Business plan: To get a bank loan, your company needs a solid business plan with a highly experienced and credible management team. These requirements reassure the bank that its cash is being turned over to a third party who knows how to run a business and generate profits. Any plan that a bank reviews that's short on these items will certainly lead to strike five.

Realizing how lending policies have changed

Since 2007, nearly every bank has been maligned, fairly or not. The frustration with the banking industry, at both the personal and business levels, has been well documented and has reshaped the banking industry's role in the capital markets. For example, prior to 2007, a bank may have been able to bend a little when extending credit to a good business that had some flaws (such as a relatively high debt-to-equity ratio). However, businesses are now being treated to a new normal that makes securing loans much more challenging. Banks still play a vital role in the capital markets, but businesses must clearly understand when a bank can provide debt-based capital and when it can't.

If your business meets the five criteria outlined in the previous section, then approaching a bank is appropriate. Banks are always looking for A/A+ deals, and if your business qualifies, then taking advantage of this source of debt capital is advantageous because it usually carries far lower fees and interest rates than other forms of debt-based capital. However, if you fail to meet just one of the five criteria, then banks may lose interest, so it's imperative that businesses understand the alternative forms of debt-based capital available. And if you fail two or more of the criteria, then bank-financing options will likely be very limited, so the next step in securing financing is to explore the wonderful world of asset-based lending.

Making friends with asset-based lenders

Asset-based lending utilizes the same criteria as banks but with one critical difference. Asset-based lenders (ABLs) focus on the quality of the asset (such as trade accounts receivable or inventory) being offered as collateral first and the company's financial performance and strength second. In fact, ABLs often look past one or two years of poor financial performances and are more comfortable with weak balance sheets because they understand that businesses sometimes experience problems (look no further than the 2009 recession and its impact on businesses). However, similar to banks, the need for sound collateral, solid secondary repayment support, and a well-developed business plan are essential to secure a loan.

But ABLs have a hidden benefit that a business should exploit when appropriate: ABLs may extend higher borrowing levels against certain assets than banks. For example, banks tend to be more conservative and may advance only 75 percent against eligible trade accounts receivable, so if you have $1 million of eligible trade receivables, you can borrow a maximum of $750,000. If the collateral strength of the trade receivables is strong, an ABL may lend 80 or even 85 percent against the eligible trade receivables, which would allow you to borrow $800,000 to $850,000. The additional borrowing availability may not seem like much, but when cash is tight, having extra dollars of liquidity is invaluable.

So, you may ask, why not skip the bank and simply secure financing from an ABL? Well, ABL lending is more expensive. From the interest rates charged on the loans to the fees assessed to manage the relationship, the cost of ABL-provided financing is much higher than with traditional banks. Keep in mind, however, that an ABL absorbs additional risks with weaker companies and thus requires a higher rate of return.

Another downside of an ABL is that you need to be prepared to implement much tighter management reporting requirements than you would with a bank. Whereas a bank may require monthly reports and information, ABLs often look for weekly or, in some cases, daily reporting procedures to be implemented to properly track and manage the assets they're lending against.

Leasing as a source of capital

Leasing or renting an asset is an effective source of debt-based capital. The most common example is leasing office space. Instead of tying up cash in purchasing a building or investing in leasehold improvements, most companies simply execute a lease with a landlord.

For example, an e-commerce retail company was growing rapidly and needed additional warehouse and distribution space for the company's products. Adjacent space was available but needed a number of improvements to be workable. Instead of making the improvements itself, the retail company negotiated with the landlord to make the improvements and then simply increased the rent proportionately to cover the additional costs. This arrangement allowed the retail company to utilize cash internally and finance the building improvements over the life of the lease (which was at a very reasonable rate).

Leases are most commonly structured with assets that have an extended life, such as buildings and capital equipment (manufacturing equipment, furniture, computers, autos, and so on). Structuring leases for capital equipment are also used extensively in the business community and provided by numerous financing or leasing companies.

Going over leasing concepts

Before diving headfirst into leasing, brush up on the following key concepts and risks:

• Risk of ownership: Most equipment leases are structured to transfer the risk of ownership to the lessee, so insurance, property taxes, maintenance, and so on all fall on the shoulders of the party leasing the equipment. But the leasing company has a secured interest in the asset being leased (to protect their interests). In other words, in most cases, the leasing company retains legal title to the assets being leased. If the business (lessee) defaults on terms of the lease, the owner (the lessor) can repossess the asset.
• Real financing cost: Understanding the true cost of a lease in terms of the implied interest rate being charged is important. Leasing companies use all types of tricks and tactics to improve their returns, including requiring payments to be made in advance (for example, on the first day of the month rather than the last), having the first and last months’ lease payments made in advance, structuring fair-market value buyout options, and so on. Head over to Chapter 3 for a discussion of rates of return.
• Used versus new equipment: Leasing is best utilized when the equipment is new rather than used, because the interest rate charged and the amount of lease financing provided will be most favorable to the lessee. That's because the value of used equipment doesn't provide the lessor as much collateral as new equipment. Attempting to secure lease financing on used equipment is difficult and expensive.

The bottom line in equipment leasing is similar to traditional borrowing. The leasing companies generally take on higher levels of risk than a bank and, as such, demand higher returns (so leasing tends to be more expensive than other forms of debt). But leasing companies often extend leases based on 90 to 100 percent of the equipment's new value, so instead of having to place 20 percent down on the asset (with a traditional bank loan), more cash can be conserved inside the business when using leases.

Making a decision about leasing

In every debt-based financing decision, the borrower needs to make a critical decision based on the trade-off between higher financing costs and access to additional capital or cash. In other words, if the excess cash can be invested or used in the business to generate returns greater than the costs of the financing, then using more-expensive and flexible financing programs is appropriate. One mistake commonly made by businesses is that they're so consumed with making sure they get the lowest interest rate available that they don't consider the impact the loan agreement may have on restricting available borrowing levels and access to cash. In a number of cases, paying a little extra for higher loan balances and/or access to cash is well worth the added expense.

Tapping government programs and the SBA

Government lending programs, at both the state and federal levels, are accessible for businesses. The most popular program at the federal level is provided through the Small Business Administration, or SBA, which offers programs geared toward real estate (for owner-occupied buildings) and general business working-capital requirements. Contrary to popular belief, the government isn't handing out free cash (hard to believe, right?) and in fact applies similar underwriting criteria as the banks.

The government relies heavily on the banking industry to market and underwrite SBA loans. As such, the common perception that loans from the SBA are readily available and easy to obtain is a myth. In fact, securing an SBA loan can be more time consuming and challenging than a traditional bank loan.

In addition to the federal government's SBA program, various states also have lending programs to assist small businesses. The availability of these programs has declined over the years as state and local governments struggle with large budget deficits and limited financial resources.

Using other sources of debt-based capital

Numerous other forms of debt-based capital are available, and two common sources are particularly worth highlighting:

• Factoring receivables: When trade accounts receivable are factored, technically the receivable is sold to a third party who becomes the owner of the receivable (as cash is paid to the seller). Unlike banks and ABLs that lend against an asset (and thus the asset remains the property of the company), in this case, the asset is actually sold to a third party. When the customer pays, the cash goes to the factoring company and the transaction is completed. Factoring financing agreements are used in a wide range of industries, and as with all forms of debt financing, they carry both pros (high advance rates and quick turnarounds) and cons (they're relatively expensive).

  Factoring trade accounts receivable involves selling an asset to a third party who then may notify your customer that the receivable has been sold (and where to properly remit payment). Needless to say, this may send a negative message to your customer in terms of the financial strength of your business (they may wonder, are you that desperate for cash?). When factoring agreements are used, you must properly communicate the transaction with customers to prevent misunderstandings or misinterpretations. The last thing you want to do is surprise your customers by introducing an unknown third party into the business relationship.

• Subordinated debt: Quite often, parties with a vested interest in a business may provide loans in the form of subordinated debt. The loan often comes from an owner or related third party. Subordinated debt has terms and conditions established just like other types of debt but are offered a lower security position in company assets than senior lenders. That is, if a company liquidates, a holder of subordinated debt stands in line behind more senior lenders when making a claim on assets.

Getting Creative with Capital

Banks, leasing companies, and other lenders are all viable and accessible sources of debt-based capital, with specific characteristics that give each source competitive strengths and weaknesses. However, the discussion of sources of capital wouldn't be complete without looking a little deeper into some creative capital sources that are often overlooked.

The number of creative capital sources is endless, so rather than attempt to cover every trick of the trade, the following sections present diverse examples to provide you with a sense of how businesses manufacture capital.

Generating internal cash flow

The ultimate goal of business owners and managers is to understand, generate, and manage internal cash flow. To be quite honest, the best way to get capital is to look internally and manage business operations more efficiently to produce additional capital. Positive internal cash flow is both readily available and logistically much easier to secure. However, you need to keep in mind that positive internal cash flow must be managed and invested appropriately in the best interests of the company and its shareholders.

Leveraging unsecured creditors

Beyond generating additional cash from internal management efforts, a business is often afforded the opportunity to utilize creative forms of unsecured financing from vendors, partners, and customers. Following are three such examples:

• Require customers to prepay 20 percent of their order as a requirement to start the production and future delivery process. In addition, terms such as 20 percent down, 30 percent upon half completion, and the remainder due upon delivery can also be utilized. Companies that produce and sell customized products often use this strategy because active alternative markets generally aren't present for “one of a kind” items.
• Ask key product suppliers to grant extended terms from 30 days to 90 days during certain seasonal periods (for example, to support higher sales during the holiday season). After the determined period, terms are brought back to 30 days when the cash flow from the increased sales catches up. Retailers often use this strategy during the holiday season as inventory levels are built up from October through November (with cash receipts realized in December and then used to repay the extended credit granted from its suppliers).
• Work with a downstream customer to obtain funding to develop a new product or technology that can greatly improve the customer's future performance. For example, a hardware technology company may need to ensure that software is available for use with its new products. Hence, a capital infusion into the software supplier to develop the technology for which it receives a royalty from future sales may be warranted.

Going after government aid, gifts, and grants

Governments, universities, and nonprofit organizations have resources available in the form of grants, low-interest-rate loans, incentive credits, gifts, and so on intended to be used for special interests or purposes. The general idea is to provide this capital to organizations that will use it in the best interest of the general public. For instance, biotechnology companies often secure research grants for work being completed on disease detection, prevention, and possible cures. Educational organizations may receive grants that help retrain a displaced group of workers or untrained work force.

Partnering up

One way to secure capital is to partner with an individual or business that's in a stronger financial position. For example, a software company was in the process of developing a new fraud-protection system for use in the banking system. Not only did the development of the system need to be capitalized, but the initial marketplace launch also required capital to ensure that the end customers, mainly banks, could review, test, evaluate, and implement the systems. Internally, the software company didn't have enough capital to finance this project, so it acquired a sister company (related through partial common ownership) that was producing strong internal cash flows. The software company issued its equity in exchange for all the assets of the target company (which in effect was the future cash-flow stream). This trade provided the software company with sufficient cash flow to fund system development and market it to the banks.