Borrowing to Build Your Business
Let's look at each of these cases and some scenarios in which borrowing actually makes more sense.
First, why would you want to borrow instead of getting investors? Simply put, borrowed money is cheaper than invested money. Business loan rates are currently in the neighborhood of 8-12% interest. Venture capital and angel investors, on the other hand, are typically looking for rates of return more like 20-30%. And if your business is successful, it could be costing you even more than that.
With that in mind, perhaps the better question to ask is when would you want to have investors instead of just borrowing the money? The most common situation is that you have a great idea, business plan and management team, but minimal or bad personal credit, no collateral, and no current cash flow from which to pay back a loan. In other words, you're a high credit risk.
Flipping that back around, if you have fairly steady cash flow with which to pay back the loan, or perhaps a large order that the loan is enabling you to handle, then a loan makes far more sense than getting investors.
So when might you want to borrow money instead of just bootstrapping, i.e., funding your growth from actual revenues? There are a couple of good reasons to borrow money for your business.
The first is cash flow. Growing businesses often have very uneven cash flow. What do you do when you have deals and receivables coming in, but rent, utilities and payroll are all due to be paid on the first of the month and you don't have the cash on hand? This is where a line of credit loan is especially handy - you get authorized for a certain amount -- say, $50K or $100K or whatever -- but you only borrow as much as you actually need to get through the cash flow crunch, and as soon as the money comes in, you pay it back. This helps keep your interest costs down.
A second good business case for borrowing is to take advantage of a short-term opportunity. Let's say you have a customer that wants to place a very large order (or hire your services for a large project). You may need to purchase materials and equipment or hire new employees or contractors in order to execute the order, but you may not be able to get enough (or any) payment up front from the client (though I certainly recommend trying to!). Or perhaps a new market condition (a competitor going out of business, a hot consumer trend, etc.), creates a particular short-term opportunity, and you want to be able to ramp up your marketing quickly to take advantage of it.
So debt financing isn't a last resort - for certain situations, it's exactly the right choice.
There are many forms debt financing can take. For example, besides a conventional business loan, there's also trade credit. Some vendors may be willing to set you up on "net 30" or "net 60" terms, giving you a little extra time to pay. This is especially helpful in evening out your cash flow. And if you have one of those short-term opportunities, your suppliers may be willing to work with you if you explain the situation -- after all, it's more business for them too, right?
Another form of debt financing is business equipment leasing. This can be especially helpful when opening or expanding a new office or facility. Consider it especially for big-ticket items that you may want to upgrade in a few years, such as computers, copiers and printers.
If you are going to talk to a bank, there are a few things you'll want to do before you apply for a business loan, including developing a business plan and preparing financial statements. You'll also need to make sure you fully understand the terms of the loan and consider things like collateral and guarantors (co-signers).
Even if the bank says no, there are still other alternative funding sources, such as private lending. Yes, they typically charge a higher interest rate than banks, but they can also offer more flexible payment plans and typically act as a personal resource much like an investor does.
Of course, there are always business credit cards. The danger there is that if managed improperly, you can end up paying 18-25% interest and get tempted into making the minimum monthly payments and taking forever to pay it off. But managed well, a business credit card is very effective at giving you 30-45 days of float on your money -- especially important for things like business travel. If you manage your money well, though, and have a card that gives you some kind of perks like cash back or airline miles, you can actually do some pretty cool things by buying big-ticket items on your card. Put the $20,000 in expenses for a trade show on your credit card and get your airfare there for free!
So don't be afraid of debt financing. If you have issues with your personal credit, then by all means be extremely cautious about getting into business debt. But if you're a responsible money manager, there are many situations in which borrowing money makes good business sense.
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