I work every day with company founders who are grappling with the challenges of driving business growth while keeping their finances on an even keel. One topic we often discuss is how to take advantage of debt to drive business growth — without it turning into a problem.
In my experience, debt can serve as a valuable piece of a company’s capital structure. The key is to use debt for the right purposes and to understand the implications of doing so. For example, short-term loans (one to two-year terms) are useful for financing receivables and inventory to help manage cash flow. These working capital facilities have attractive interest rates (often in the 5% range) and are well understood by the lending community.
By contrast, mezzanine loans (usually three to five-year terms) are better suited to provide the flexibility and runway needed to prove out certain initiatives prior to securing an equity investment or a liquidity event. These loans tend to have limited covenants, are not secured by specific working capital assets and are junior to the working capital loans. Given their higher-risk profile, they are more expensive than short-term loans, with lenders typically targeting a return of 15% to 20%, split between a current pay interest rate of 10%+ and expected stock appreciation from the receipt of warrant coverage.
Regardless of the type of debt a company takes on, there are certain principles to consider to keep the debt from threatening the success of the business. Should you decide to take on debt, understand the implications and consider the following five rules:
Don’t treat debt as a replacement for permanent capital
Think of debt as part of the solution, not a long-term strategy to fund losses. Debt has to be paid back and is not a sustainable way to fund losses that can begin to mount when you are pursuing rapid growth. It often makes sense to mitigate the risk of debt by also partnering with an equity investor.
Don’t let easy access to credit give you a false sense of comfort
These days, there’s plenty of credit to go around, and it’s easy for a fast-growing company to fall into the habit of drawing down debt. If you borrow funds, make sure you can meet all the covenants, and service the debt to avoid any surprises. Not to scare you, but working capital facilities often involve the company moving its banking relationship to the lender and providing the lender the ability to sweep your cash account in extreme situations.
Don’t wait until you need credit before approaching a lender
The best time to take on debt is when you are financially strong and don’t need it. If you are raising equity or have just received funds, you are in a strong position to access debt. One strategy is to secure a line of credit, so that you have it ready to go even if you don’t use it right away. By contrast, if you wait until your working capital needs become an issue, it could become harder to reach agreement on acceptable terms.
Don’t underestimate the impact of back-loaded repayment terms
Pay close attention to the repayment structure of mezzanine loans. If you take out a five-year loan, for example, you might be required only to pay interest on the loan for the first two years. This can make those payments feel manageable, but the principal amounts due in subsequent years may creep up on you. At the end of year-five, you might even be asked to make a “bullet payment” representing the remaining loan balance. Time moves quickly and you want to avoid putting yourself in a compromised position.
Don’t keep lenders in the dark about your challenges
Lenders really don’t like surprises. The best way to work with them is to be 100% transparent. If you’ve had a couple of quarters where business performance fell short, don’t gloss it over with the idea that you’ll just make up for it next quarter. If you communicate with your lender regularly about the positive and negative factors that could impact your business, you’ll be in a better position to build and sustain trust, which will impact not only that particular loan, but all future business you might do with that lender. Lenders can and should be your allies in building a strong business, and it all starts with being transparent and treating them as a partner.
One role that I love to play at Volition is helping founders find the right lenders for their business and goals. Lenders need to understand the dynamics and the risks of the borrower, and how the capital will be used. When a loan officer really gets it, the stage is set for a strong relationship moving forward. Lenders typically appreciate having a firm like ours involved in the process to mitigate the risks of having an underperforming loan and to maximize the opportunity.
In conclusion, whether you are working with a partner like Volition or not, understanding the implications of using debt will empower you to make the right decisions for your business.