Debt Can be an Essential Element for Fledgling Small Businesses

Starting or growing a new business debt-free may seem like the best way to ensure a strong company, but this is not always the case. Debt is not a dirty word. If you take on debt wisely and with a great deal of forethought, it can make the difference between great success and constant struggle.

To make wise choices, you have to have the right mindset and understand that different types of debt make sense in varying situations. Here are some things to think about before taking the debt plunge.

Before Taking on Debt, Answer Some Basic Questions

Once you recognize that your business needs more cash, do not run out to your local bank for a loan without first looking more deeply into your circumstances. Make sure that you have the right answers to the following questions:

  • Do you have a clear picture of your personal finances? If you have a personal nest egg, you might be tempted to just write a personal check to take care of your business’ financial needs. But, while you’re waiting for two or three years (or more) for your business to earn a profit, will you have the personal funds needed to live and handle emergencies? Unless you plan to live at your office and sneak food from the vending machines, do not plan to put any more personal funds than you can afford into your business.
  • Why do you want to take on debt? Debt that helps your business grow can be good debt; debt that will temporarily stop the bleeding may not be wise. If you know that additional funds will fix what ails your business or you need extra money to get to the next level of growth, then debt might be the way to do it. But if more money will not fix significant issues in the business, then perhaps it will just delay the inevitable. Of course, you may have financing options other than loans, as long as you proceed with your eyes wide open.
  • Are you willing to give up equity, or do you need a loan? Loans are pretty straightforward. Someone gives you money, and you pay it back with interest. A business loan calculator can provide a preliminary high-level view of what you would really pay for a loan, but don’t count on it for full accuracy. New businesses do not always that have sufficient collateral or evidence of trustworthiness to qualify for typical loans, but other sources may be available. Another option is to give up a percentage of ownership (equity) in exchange for an investment.
  • How much debt do you currently carry? If your business already carries debt, then you have to decide if you can afford to take on more. The key is to accurately know your numbers and then add a little intuition to predict whether more debt will help you to become more profitable or hinder your operations. We’ll look at a formula that will help in just a moment, so stay tuned.

Get Creative When Considering Financing Options

You probably have more options than you realize when it comes to asking for money. First, decide whether you plan to pay it back or if you are willing to give up some ownership in your business. Then select from a variety of options, such as the following:

Loans

Bank loans may be an option, but they may be less than willing to loan to very young startups. Another option is the “Three Fs,” (friends, family and fools). This may not seem like the nicest moniker for the people in your life who may be willing to loan money (or invest), but they may be the best choice, particularly if your business is only in the idea stage.

The Small Business Association (SBA)

If you can’t get a bank loan outright, you might consider applying for an SBA Loan. The SBA doesn’t actually loan the money, but they might provide a loan guarantee that gives your request more weight with the bank. These loans are not open to all small businesses, so read up on the requirements before you apply.

Equity investments

In a nutshell, people who provide funds in exchange for partial ownership in your business are commonly known as equity investors when they invest their own money or venture capitalists when they manage investments from funds. Of course, this is an oversimplification of a complex topic.

Equity investors come in many flavors. Three F investors might fall into this category if they obtain shares of the business, and they may be the only investors willing to put money down based on their confidence in you while your business is still in the idea stage. Angel investors, on the other hand, base their decisions on business prospects — not so much on how they feel about your personal abilities. They are willing to invest in young existing businesses, but they look for high returns, typically within three to five years.

When giving up equity, You might also consider how much knowledge an investor brings to the table. You may not have the good fortune of enticing Marcus Lemonis from The Profit or someone from Shark Tank to invest, but a knowledgeable and involved investor may have the insight and contacts to grow the business in ways that you never imagined. Even if you give up a significant percentage of ownership, this type of partner can bring more money to your pockets than if you owned every share. But, partner is the operative word. Make sure that you choose them as wisely as you would choose a spouse.

Crowdfunding

In its traditional form, crowdfunding was a non-equity source of funding. As a general rule, companies offered some other form of return on investment, such as early releases of the company’s product or other types of gifts. But now, as explained in our article, JOBS Act Crowdfunding Options, even crowdfunding can be included in the Equity Investments category. Read up on the opportunities and limitations of the crowdfunding options.

If you think that crowdfunding is a simple way to request start-up contributions, think again. It’s not as easy as just setting up a web page. According to a must-read Entrepreneur article for anyone considering crowdfunding, success comes to businesses that work hard, plan thoroughly, have the right kind of product and more.

Also check out our article, Getting Ready for Crowdfunding to learn about the ins and outs of this type of funding. If done correctly (and for the right reasons), crowdfunding can make a tremendous difference to companies looking to get their projects off the ground. One example: since its 2009 launch, over 129,000 entrepreneurs have successfully funded projects on Kickstarter alone.

Alternative Lending Requires Good Research

Of course, this information is just an overview of your options, and you need to research each choice carefully. Here are three articles about alternative lenders from our own site that can help you get started:

You Can Partially Replace a Crystal Ball with a Formula

Obviously, your decision to take on debt depends on anticipated future results. You want to use debt only when you expect the return to be greater than the cost. You can’t avoid looking into your crystal ball to help predict a winning venture based on your knowledge of the business and customer interest, but you want to base your predictions on pure math as much as possible.

Check out the Quick Books article that asks Does Your Business Have Too Much Debt? It clearly explains how a simple formula, known as Debt-to-Equity Ratio can help you figure out if you can afford to take on debt. Simply divide total debt by an accurate appraisal of your total owner’s equity to arrive at the ratio.

So, if that ratio is 1.5, it means that you owe $1.50 for every $1 that you own in the business. Whether that ratio is good or bad depends on your industry. According to CSIMarket, a typical debt-to-equity ratio for the financial industry is 1.86, but it’s only 0.50 for conglomerates. You need to research your industry to decide if you can take on more debt or not.

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