Young entrepreneurs generally seem to be reluctant to consider using debt to help finance their businesses.
The reasons they cite are many. Often, they are concerned that they already have a heavy debt burden due to student loans from college. Others tell me they watched their parents get deep into debt and don’t want to do the same. The requirement to sign personal guarantees for business debt terrifies many young entrepreneurs. More than a few tell me that Dave Ramsey’s anti-debt message shaped their negative perceptions about debt.
When I tell my students that, generally, I prefer debt over equity financing, I see shock on many of their faces.
Bad Debt
There are certainly many instances when taking on debt financing for a business is not a prudent decision.
When I hear of entrepreneurs maxing out credit cards to finance a startup, it sends shivers down my spine. I know that there are countless stories in entrepreneurship magazines about “heroic” entrepreneurs who went tens of thousands of dollars in debt with credit cards to create incredibly successful businesses. But for every successful use of credit cards to launch a business, I have seen dozens who end up with failed businesses and mountains of credit card bills that haunt them for years.
Bankers can tell countless stories of business owners with business models that are no longer competitive seeking loans to keep their failing businesses afloat. Rather than keeping these businesses on life support by continuously pouring money into them, these entrepreneurs need to come to the hard realization that they have come to, what I call, an “Old Yeller” moment. Sad, but true.
Some debt funds short-term needs for cash, while others fund longer term investments in your business. However, sometimes we use debt for the wrong purpose. For example, when I was a young entrepreneur, I used a line of credit to invest in things that were actually tied to growth capital. A line of credit is meant to fund short-term timing issues with cash flow, such as funding inventory purchases or paying for payroll on a project that will be billed upon completion. I used it for hiring staff and adding new space that would take much longer to generate cash flow.
Fortunately, I had a good banker who helped coach me on the proper uses of lines of credit. He also provided us with a long-term term loan to use to fund the investments we needed to make in staff and space to grow our company. I never made that mistake again!
Good Debt
Good debt begins with debt that your business and you can support. This is how bankers make decisions on making loans.
Bankers always look to multiple means of repayment when making business loans. The first source of repaying is a healthy business with more than enough cash flow to fund the debt. The second line of defense to ensure loan repayment is the personal guarantees of business loans by the business owners. If your financial house is not in order, your chances of getting a loan for your business are diminished. Finally, bankers will use assets pledged as collateral to pay off business loans, but only as a last resort.
“Bankers only give loans to people who don’t need it,” is a common refrain I hear from small business owners. The reality is, bankers only give loans to people who they are highly confident can repay those loans. After all, it is our deposits in the bank that they are using to fund loans.
Bankers understand what makes good debt, and you should understand and follow their criteria for using debt.
Use With Caution
The requirement of personal guarantees are a sobering aspect of taking on a loan for your business. Keep in mind, personal guarantees are not only a financial tool used by banks. It is also a psychological tool. If you are not confident enough in your business to personally back the loan, then why should the bank?
Another risk with taking business loans is that although your business might be solidly bankable when a loan is made, times can change. We need to look no further than the thousands of loans that went from safe and solid earlier this year, to being rated as highly at risk for default after pandemic took hold.
When you need to use debt, make it a priority to pay down your business loans as quickly as possibly. Certainly, don’t pay off your loans so aggressively that it hurts your cash flow. However, once you have a good cash position, the next most important goal is to pay off your loans.
The reason I prefer debt to equity is that debt is like a house guest. When you pay it off, it goes away. Equity is like adding a new member to your family. Once you take their money, they are there to stay!
Debt is a scary thing to me as is to many young entrepreneurs. I am another entrepreneur that is just in general scared of it. It is a good reminder to consider that versus equity in the company. As you said, debt is fine as long as you have the confidence and the means to pay it back. Credit card loans have never seemed like a smart way to go about supporting a business to me either. It’s bizarre to me that they push any success stories about it. If you are going to go into debt for your new company, definitely business loans are the way to go.
Most people, especially young adults, tend to not think of debt as a good thing. I think more times than not, people see debt as a scary thing rather than an opportunity. Correctly using credit to expand your company can be so beneficial and in the long run be worth going into temporary debt. When people are driven and ambitious, they will tend to not see the negative side effects of their operations. They may continue to put themselves into debt and say they will “be able to pay it off in no time,” failing to consider that cutting their losses might be the best solution for them financially.
I also naturally feel reluctant to use debt to help finance a potential business, so learning about “good debt” and “bad debt” was very helpful for me. I think a common misconception with students my age is believing that banks only give out loans with sneaky plans to screw us over with high-interest rates, but I learned that bankers only give loans to people who they are confident can repay those loans. At the same time, it is critical to pay off business loans efficiently without hurting cash flow prematurely. I also appreciated your emphasis on learning how to wisely and properly use lines of credit in a business, such as using long-term loans to fund investments like staff and space instead of short-term lines of credit. Very helpful!
Debt is a frightful word for people every time they hear it. Debt is like most things and can have a positive connotation. If you are going into a small amount of debt with a guaranteed larger payout, then you do it. Most people in college are going into student loan debt that can cripple you, which is a bad kind of debt. Bad debt can accumulate in small increments to build up over time like a snowball rolling while getting bigger. As long you’re taking the proper steps and have plan with your debt then it can have a much less negative connotation.
One thing about debt is I know from learning from my parents don’t ever forget to pay your bills on time or make all the payments you need due on time so you won’t be in debt. Also don’t purchase things without having the money for it. But in the intense of doing it for a company to become a-thing by using credit is a good source of debt and will most likely be paid off if you keep up your work ethic into earnings those debts back.
The idea behind good debt is that you, as the entrepreneur, are willing to put your stake in that debt. It is not just some flippant decision to spend money, but it is something that you feel comfortable guaranteeing with the shirt off of your own back. To me, bad debt is something that isn’t meaningful to you and that you don’t think very hard about, and then can end up owing an incredible amount of money for. If every entrepreneur were to stick to only good debt, there would be many failing businesses that would not even get to the point that they had the chance to fail, because they wouldn’t have the funding!
I really like the idea that there is a such thing as “good debt”. Often times, I feel that debt gets a bad wrap, because of the fact that you owe someone money. As you said, debt will eventually go away, but new partners in your business are here to stay!
Even without having my own business, I would be someone that is reluctant to use debt. Although I nor my family has been in debt, my dad continues to tell me that once you get in it, it is very hard to get out.