10 Ways to Manage Business Debt

In many years of dealing with banks and other lenders, I have learned the positive and negative aspects of using business debt.  My career includes positions as a full time CFO in four companies as well as over twelve years as a Consulting CFO to startup companies in Silicon Valley. Having successfully borrowed many millions of dollars in multiple companies and deals, I can offer lessons learned the hard way that can be of value to those thinking of taking on debt may help their business grow, or resolve ongoing cash flow issues currently existing.  This brief goes over many of the forms of debt and discusses tips on using debt and managing the relationship with lenders.  It encourages good cash flow management and using debt only when it is appropriate within the business and when it can be successfully be repaid.

Debt financing can be a real help to business in the management of cash resources. However there are many forms of debt and not all forms will work for all business types.  In fact, there are times where taking on debt can be the wrong solution to a business problem, and allow a company to overexpand or make inappropriate acquisitions that the company cannot afford.

As there are many forms of debt, it makes sense to focus this piece on debt that would be available to small to medium sized business (“SMB’s”). In a large business with an investment grade credit rating, commercial paper, corporate bonds and the like can provide low cost financing not available to more modest business. Further, the large business may have more predictable cash flows reducing the risk from taking on new debt.

Debt can take many forms, too many to describe here. Some forms of debt available to small to medium sized business and are subject to this discussion include:

• Bank debt often tied to assets such as accounts receivable or inventories
• Finance Company debt often tied to accounts receivable, equipment or inventories
• Venture Debt typically secured and with a stock warrant provided to the lender
• Friends and Family Loans
• Credit card debt, corporate or personal
• Vendor payment terms
• Equipment Leasing often from the vendor
• Government and SBA loans
• Factoring of accounts receivable
• Letters of Credit often for imports or to secure other transactions

Regardless of which form of debt a firm chooses to seek, there is no assurance that debt financing will be available or under what terms.  There is no better example than the freeze in lending that occurred to small to medium sized business beginning in 2008 with the near crash of the financial system worldwide.  Our recovery from this freeze has been quite slow.  One should also keep in mind the obvious fact that debt must be repaid with interest.  Quite often I hear entrepreneurs speak of debt as “financing” in the same manner as raising equity capital.  In such cases, when the inevitable time of interest and principal repayment occurs, the difference can become pretty painful.

The thrust of this paper is to describe ten ways in which a firm can evaluate and manage its debt exposure. As part of this discussion, I will refer to many of the above forms of lending.  Below is a brief discussion of actions a firm can take that will help it to make the right decisions:

1.  The most important consideration for SMB’s is to separate clearly the need for debt from the need for equity. I often hear firms say that if they could only borrow more, they could expand their business. This may or may not be true. It takes time for money spent on business expansion to create positive cash flow. For example, borrowing money to open a new retail store as part of a chain of stores.  There will be initial facility lease costs and deposits, acquisition of fixtures and inventory, hiring employees, legal costs and the like. It will take time for customers to find the business. So when will cash flows from the new store be sufficient to allow payback of the amounts borrowed; perhaps long after the lending agreement says it needs to be repaid. This kind of expansion might better be funded by equity investors or from positive cash flow from existing stores. In planning, the firm must carefully plan its cash flows using a good financial model and realistic assumptions.

2.  Establishing relationships with financial institutions is key to having debt financing available when it is appropriate. Regardless of whether a business is new or has been around for a while, the banking relationship should not be taken casually. Select a commercial bank that lends and depends on success in your industry. Speak with similar firms for referral to a loan officer that can speak your language. Open your principal account with this bank and become an important customer from a deposit and operational point of view. They will then know your firm when you seek a loan.

3.   Having established your banking relationship, don’t end it for a small difference in terms or interest rate. It may make sense as part of a debt acquisition to seek pricing from competitors. But just because you have a term sheet from a competing bank that seems better, you have not been to their credit committee and this bank will have no experience with your operation. You may wind up ending a great relationship by going elsewhere and then get a refusal from the new bank when your deal goes to committee. 

4.  Careful management of your credit line is critical to staying on good terms with your bank. For example many credit lines are established based on accounts receivable balances. As you collect from customers invoices that are part of the collateral, you may need to make immediate repayment to the bank to keep the aggregate line within the allowed percentage of total AR balance. Not managing this carefully can create a situation in which you have spent money on other things that is needed to keep your line within allowed balances. This can put your firm into default on your loan.

5.  It is easy to borrow to finance equipment, particularly from vendors that have captive finance arms to promote sale of their goods. However if this kind of financing is dependent for repayment on a positive cash flow from the equipment acquired, then careful planning is required to assure that this is the case. Other owners of the equipment should be referenced to see if they have saved the money you are expecting to save and how long it took them to get there. Such an acquisition, for example new manufacturing process equipment, will look pretty ugly if cash flow does not improve but the monthly payment is there anyway.

6.   If your firm purchases large quantities of goods and services, such as a distributor or manufacturer, then attention paid to the terms of purchase can result in a form of vendor financing that works well for many firms. For example, you may purchase materials and through negotiation find a vendor that will allow 60 or 90 day terms of payment either for all orders or for large purchases or promotional orders. If you don’t ask, you won’t find out if such financing is available. But, expect to find the cost of the financing in the cost of the materials; further don’t think you can get away with slow payment and not bother to negotiate terms. Vendors will have ways to get back at you, or you will be last in line when goods are in short supply.

7.  Don’t fall into the trap of using credit card debt to substitute for other debt you can negotiate at lower interest rates. While this form of debt may be unsecured for some firms, interest rates are never cheap. Use credit cards only where appropriate and pay off the balances monthly. I recommend that your employees that travel obtain their own credit cards with the company paying the annual fee. This keeps the debt off the company’s books and makes the employee responsible for promptly turning in expenses.

8.  The overall cost of debt includes not just the interest rate but the terms and conditions under which it is obtained. Debt agreements can contain :”loan fees” to initiate the credit line, legal costs for loan and security agreements that are charged to the borrower, costs of bank audits of the collateral and the cost of annual CPA financial statement audits if such are a part of the overall credit agreement. These costs can make an otherwise acceptable interest rate much higher, particularly the costs of the CPA audit which can run many thousands of dollars including the disruption of conducting the audit. So negotiate carefully keeping the full cost of the credit in mind. Should you choose factoring of invoices as part of your financing, be sure to calculate the full cost of the discount provided to the lender and the actual number of days financing you receive as compared with the actual payment date of the vendor. You might find the cost very high for only 20 to 40 days of financing.

9.   If you are willing to pay the legal fees, you can issue various kinds of convertible debt which can be sold to private investors including friends and family. Often this debt can be automatically converted into formal equity rounds when and if such can be arranged with venture capital and private equity firms. If you are able to sell this kind of debt, you are typically cash flow negative and it is best that the terms of such notes make it hard to get the company into default and when in default there are few if any penalties. To entice folks to buy these notes, interest is paid (usually in stock on conversion), and there may be a stock premium over what is issued in the formal equity round. Ideally if you are unable to arrange the expected equity round, it is best that any right of repayment be subject to the ability of the company to pay, so that the existence of the firm is not threatened.

10.  Letters of credit can be quite useful particularly if you are an importer to avoid laying out cash that would otherwise be needed to secure needed parts or other commodities. But LC’s need to be managed as debt, as once issued, all the receiving party needs to do is to complete the terms and issuer is out the money. The bank issuing the LC will charge it immediately to your credit line, so try to get a separate line for LC’s from the bank. You must pay attention to the exact terms and words written on the LC document and use your bank’s LC department for advice to be sure that payments are made on the LC as you expect. For example, if the goods need to be inspected before payments, then by whom and the proper documentation need to be in the hands of the bank before payment.

This checklist is by no means all one needs to know to effectively manage debt in a SMB but the information provided here can certainly help.

I certainly hope readers of this brief will consider that when taking on debt in their business, they have made a serious step with many consequences some of which may not be intended.  I urge managers considering use of debt to very carefully model the cash flows of their business using a financial model that is fine tuned to predict cash flows.  In the absence of such a model, the ability to determine how long the borrowed funds will last, whether the borrowing solves the business problem at hand, and whether there is cash flow to fund repayment when due are all questions that will be very difficult to answer. Do not accept a model that does not include a full balance sheet and cash flow and help model changes in the assets and liabilities of the company as well as its revenues and expenses. If you have not completed such a model before, I urge you to employ a financial consultant that can bring this capability to you.

Once you have determined your strategy, the next step is to contact potential lenders that fit your strategy. As with many areas of life, it is better to be introduced to a lender by a trusted acquaintence rather than just call them on the phone. Be sure to have the details you need to make the lender comfortable with your application, which will include recent financial statements, projections from your model, information about your business, ownership of your business, key customers etc. In lending, it is all about trust, so the more you can show that you are in command of your numbers and strategy, the better they will feel about presenting you to their loan committees.  Be prepared to show in your cash flow projections how the lender will be repaid.

Finally, treat your lender with respect regardless of whether they offer funds to your firm; if they are not ready now, they might be later on when circumstances are different.  You will meet the same people often years later in the same or different firm. You always want them to fondly remember their contact with you regardless of the results of the initial effort. Keep in touch with those you meet and occasionally let them know about the growth of your business.