Hey friends. Robert Band, your business finance advisor here. I have to ask, “Are you taking advantage of today’s low interest rates to expand your business by using debt? With rates so low, is it a smart time to finance new equipment or a new line of business? Today I want to demystify different types of debt and show you how and when to use each type. I’m going to start from least expensive debt to most expensive.
The least expensive is accounts payable because your vendors are extending you credit for free. I include credit cards in accounts payable, assuming you pay the balance on time and don’t incur interest on unpaid balances. My financial advice is to negotiate the most you can with your vendors and credit card companies and pay them on time.
The next most expensive is bank debt. One common bank loan is a revolving bank line of credit, which is for short-term spikes in capital needs, like building inventory before Cyber Monday. The line of credit should not be used for anything long term, like equipment because it must be paid off annually. Lines of credit are secured by collateral and often personally guaranteed by the owner. Because they are collateralized by the company’s assets, they are considered senior debt, meaning the bank is in a senior position to get paid if liquidation occurs because they hold the collateral in the event of default.
Another type of bank loan is a term loan which is payable with monthly principal and interest payments over a term of years, say 5 0r 7 years. Term loans should be used to finance long term assets like equipment or real estate. Term loans are secured by the assets they’re financing and often personally guaranteed.
Banks depend on the certainty of cash flow to repay their loans. They don’t take the kind of risk that investors do. So, their loans will be sized to fit the cash flow of your business. If you’re in the early stages and burning cash, you’ll need to turn to more expensive debt and possibly equity because banks won’t lend to you until there’s cash flow to repay them. Obviously, being able to accurately forecast cash flow is essential so engage the help of a financial advisor.
Bear in mind that debt must be repaid and thus depends on enough cash flow within the loan term to make the payments on time. Equity, on the other hand, doesn’t have to be repaid. The equity shareholders only benefit if there is excess cash flow, after debt payments, with which to distribute to them. So, if you’re thinking of debt for your business, a crucial consideration is, “will you have the necessary cash flow by the time you need to repay the debt?” If so, then debt makes sense because it’s cheaper than equity.
Next up on the world of debt is mezzanine or hard money loans, which unlike bank loans, are not secured by assets of the company. These loans make up the gap between all other debt and the contributed capital the owners have put into the company. Mezz lenders charge 15% - 30% interest rates, because their loans are unsecured, meaning they don’ t have collateral like the more senior bank debt and thus they’re taking more risk.
Mezz debt usually involves an upside kicker like warrants to purchase stock at today’s price which, if the company does well, could be worth a material amount in the future. Because it’s so expensive, mezz debt should used for interim short-term purposes, like filling the gap between debt and equity on a real estate project. For example, a real estate developer can get $8 million of bank financing for the land acquisition and construction cost of a new $10 million project. If the developer only has $1 million with which to contribute to the project, it might make sense to borrow mezz debt at 20% to fill the gap. This mezz debt is short-term and because it’s expensive, will need to be repaid after the project is built and leased up and then refinanced with a long-term mortgage.
Convertible debt is a loan from an investor who will earn interest on their loan AND have the option to convert their loan to equity in the company if the company is doing well. Banks don’t do these types of loans. Investors do. Making a loan convertible into equity gives the lender more upside than just the interest rate on their note. These loans are usually made in the early stages when cash flow is uncertain, so the investor is taking more risk. Hence, they get the upside of the conversion feature.
If the company does extremely well, it’s likely the investor will convert the loan into shares. Shares give them the right to receive their portion of the profits every year, plus their share of the sales proceeds when the company sells someday. If the company becomes highly profitable, those profits and sales proceeds will up the investor’s return substantially.
So how do you determine how much and what kind of debt to carry? First, interest expense on debt is tax deductible, which means that a loan at 4% really costs 3.16% (4% less tax at 21% corporate tax rate). Now, since interest rates are so incredibly low right now, it makes sense to finance your long-term assets like equipment and real estate as far out as possible. When rates are low, lock in those rates for as long-term as possible, but only to the extent that your cash flow permits. When rates are high, borrow short-term or not at all.
Debt is a form of leverage because it’s someone else’s money being used to finance your assets. Positive leverage is where the cash flow from the new asset will far exceed the debt payments. For example, if new robotic warehouse equipment costing $200,000 will reduce your operating costs by $75,000 per year, it would make sense to borrow at today’s rates of say 5% to buy the equipment. Annual payments of principal and interest on a $200,000 term loan at 5% over 7 years will be $34,000, which is way lower than the $75,000 you’ll save in operating costs, so this loan makes sense. If the operating savings were projected to be closer to the $34,000 debt service, I would think twice about financing such equipment because it’s riskier.
If you’re burning cash, you’re going to be looking at hard money loans to finance that burn, and you need to believe that the future cash flow will be enough to repay the loans. Otherwise, raise equity. Only raise debt if you strongly believe you’ll be able to repay it, because if you don’t your debtholder could force you to sell your company to pay them back. If you’re unsure as to whether your cash flow will turn the corner in time to repay the debt, then raise equity and take the pressure off yourself in the near term.
Projecting cash flows from new lines of business or assets you want to finance is a critical skill. If you miscalculate, you may incur debt or give up equity and have nothing to show for it. A CFO consultant is recommended for cash flow projections as well as to help you choose between debt and equity. And if it’s debt, to help you size the loan, choose the right loan type and negotiate the loan terms.
This is Robert Band, your business finance expert. Would you like better financial management that leads to better results? Then let me put the right pieces in place for you. Remember, one tip could be worth millions and profits today, through the compounding of interest, become fortunes tomorrow. So, don’t let them fall through the cracks.