Incurring debt is among the foremost of issues to owners of family businesses. Most business owners either already have debt or will acquire some in the near future. Ben Franklin may have prophesied “neither a borrower nor lender be,” but growing a business exclusively from internally generated cash flow is not always the best use of company funds.
During the fast and furious ’80s, many businessmen believed that leveraging the balance sheet was good for the income statement, and that you could grow your way out of debt. The 1990s have been more conservative and, thankfully, logical in matching debt to need and opportunity.
Common Uses and Sources
Business opportunity is the most common use of debt. This may range from working capital to more complex situations such as the buyout of a family owner. Working capital may support the introduction of a new product, increase inventory for “just in time,” allow the sales and credit managers to offer extended terms, purchase key equipment or real estate, or for sales growth. Commonly in today’s market, debt is also used to fund strategic acquisitions.
Depending on the financial condition of the underlying business, there exist several options for funding. Commercial banks, private equity, leasing companies, and asset based lenders (i.e. commercial finance companies, insurance companies, factors, or key suppliers) are the more common sources. Underwriting from these traditional sources will consider the quality and consistency of cash flow, the appraised value or liquidity of real property, equipment, inventory, or accounts receivable, future earnings projections, and management. Commercial bankers can help steer the business owner to the appropriate financing source — the source that is best suited to handle your individual needs.
In underwriting a working capital or term loan, commercial banks will emphasize historical cash flow levels, projected cash flow, the condition of the balance sheet, collateral, industry factors, recourse, and management’s abilities, depth, and character.
Alternative financing sources will rely more heavily on collateral and the asset being financed. Asset-based lenders, or factors, typically spend more time evaluating the borrower’s accounts receivable. Often, the borrower’s customers’ financial condition is paramount in determining the probability of repayment for a proposed transaction. In this case, credit worthy customers are a big help. An insurance company or leasing company may focus its underwriting on the borrower’s cash flow in tandem with the current and long-term marketability of the real property or equipment being financed.
In most cases lenders will structure a loan based on today’s performance and balance it with future projections. Financial covenants of a loan agreement will be established with consideration of expansion plans, industry and economic cycles, seasonality, and changes in ownership, as well as other business issues. For many commercial banks covenants may measure operating results, balance sheet condition, industry specific measures, and will be established with consideration given to the future of the business. Asset based lenders may incorporate covenants that are similar to a commercial bank but may structure its covenants to preserve the quality of the particular asset being financed. Repayment periods are usually aligned with the life of the asset securing the loan.
Borrower’s Considerations Debt is almost always a means to a worthy end. It can, however, be a hindrance. Some business owners may opt for building-up a cash reserve to capture future opportunities. Others may choose to tap personal resources, borrow from a trusted friend or relative, or sell an ownership stake to raise funds. The current pace of economic growth has fueled the use of debt. For debt to work to your advantage it must be managed carefully, which means adhering to financial discipline. Properly used, debt can substantially improve business profitability with no dilution of ownership. Before incurring debt talk with your professional resources — your commercial banker, CPA, attorney, and consultant. Before borrowing, consider the following and remember as a caution, don’t ignore your own business instincts:
- The quality of the opportunity at hand, its long-term viability, where are we in the economic cycle?
- Is the opportunity funding a debt risk or an equity risk? Is it project financing or can current cash flow levels repay the indebtedness if the opportunity doesn’t pan out?
- What is my back up plan if the opportunity fails or is slow to develop? Is down sizing an option to manage cash flow and debt?
- Type of debt needed; ie. short-term, long-term, senior, subordinated, repayment schedule versus the life of the asset/opportunity or the current economic cycle, the appropriate lender.
- In raising equity you gain a partner, share decision making, and dilute ownership; using debt you have sole decision making yet existing loan agreement covenants must be considered.
- How will the new debt affect the borrower’s cash flow and balance sheet condition; now and going forward? How does that compare to your industry peer group’s condition?
- How and where else can you hedge your risk to ensure opportunity success/debt repayment? Employment contracts, supplier contracts, repurchase agreements, business interruption insurance, interest rate risk contracts, maintenance contracts, etc.
Carlos Munguia is vice president of commercial banking at Bank One.