Most small businesses need some form of debt to function efficiently (with a few exceptions, such as venture-backed software companies.) Proper levels of debt not only improve company liquidity but also increase shareholder returns, allowing faster cash cycles and investment to grow your business. But too much debt, like an excess of anything in life, introduces a host of problems that often precipitate or exacerbating a liquidity crisis.
As a turnaround CFO, I have seen too many good small businesses collapse under the weight of unmanageable debt. It often starts with the owner taking a seemingly innocent loan which snowballs into an avalanche of debt that crushes the business and causes bankruptcy. Then I am hired to negotiate with lenders to help small businesses restructure debt and avoid folding.
Does your small business need debt restructuring? Here’s my advice for small businesses evaluating their debt structure and determining if they are on the path to illiquidity.
What is good business debt?
Small businesses have dozens of debt options and each debt instrument has a proper time and use. If you are not financially savvy, use my rule of thumb: if it is difficult to get the loan, it is probably “good” debt. If it is easy to get the loan, it is probably “bad” debt.
Consider a bank mortgage (very good debt.) In order to get a business mortgage you need to provide both business and personal financial statements, submit a business budget showing you can afford to make monthly payments, fill out a lengthy application, explain any unusual items in your history, meet with your banker several times to discuss the application, and, only after 60-90 days of persistent work, sign a mountain of paperwork including Small Business Association documents. As a result of all that work, you got a good business loan with low interest, reasonable debt service, and proper borrower protections.
Good business financing includes:
- Real estate mortgages
- SBA debt such as 7(a), 504, Community Advantage, Mainstreet, or EIDL loans
- Equipment term loans
- A working capital line of credit
- Convertible notes or SAFEs (common startup business loans)
These types of business debt are generally safer than other, more exotic loans.
What is bad business debt?
Bad business financing is generally short duration, high interest, and intentionally designed to confuse the borrower. Nowadays predatory small business lenders use internet-based technology to speed up the process, allowing you to make a terrible business decision in under 10 minutes!
Small business owners now received popup messages from Square, Shopify, or Quickbooks saying, “You are eligible for $10,000 small business loan! Click here to get your money!” After filling out a short online form and scrolling past the terms and conditions (without reading them of course,) the money suddenly appeared in the business owner’s bank account. That sure was easy! In exchange, they just signed up for a high interest, short term loan that bought some temporary relief in exchange for long term problems.
Every debt instrument has its proper place and time. However, the most commonly abused small business debts which we consider “bad debt” include:
- Revenue based financing
- Merchant cash advances
- AR factoring
- Credit card debt
- Any business loans with daily or weekly repayment terms
Good uses for business debt
Good debt management means using the money from the loan correctly. Good uses for small business debt include:
- Buying business real estate
- Financing new or used equipment
- Building out facility expansions
- Financing accounts receivable or inventory balances
- Issuing convertible debts to prospective equity investors
Even high interest loans can be properly used:
- Credit cards can extend AP terms and bridge irregular cash flow.
- AR factoring can be useful when a founder has poor personal credit or the business is otherwise un-bankable.
- Private equity groups use mezzanine debt financing with 18% interest rates to facilitate leveraged buyouts.
These riskier forms of debt are tools that can be easily abused. When pursuing such a strategy, work with a fractional CFO and build a budget to ensure you can increase revenue to pay off your debt.
Bad uses for business debt
All debt is bad if it is used to finance unprofitable operations.
Here’s a common scenario: Joe owns a construction company. They are half-way through a big project when his backhoe breaks and he needs to rent a replacement. Since Joe is tight on cash, he:
- Puts the equipment rental on the business credit card.
- The credit card floats the balance while Joe continues to squeak by month-to-month.
- One week he’s short on payroll so he takes a short-term loan from a lender that specializes in construction lending.
- Finally his team finishes the project, but the customer sits on his invoice without paying it for a few months.
- Joe’s outstanding debt payments are difficult to pay, and Joe takes another loan to cover payments on the first loan.
- Joe factors his receivables to advance the cash so he can start the next project.
- Joe keeps pulling money from lenders when he can, and eventually has five or six small business loans.
- Finally he cannot borrow any more money and will miss payroll, so he calls a professional like me.
Sound familiar? Rather than fix his operations problems – high expenses and slow paying customers – Joe painted himself in a corner using expensive debt. I wish Joe had called me when his backhoe first broke so we could have saved him months of stress. Nonetheless, it is better to call a professional late than never at all. I will work with Joe developing and executing a strategy to negotiate a debt settlement, lower his interest payments, or execute a debt consolidation.
When should I restructure my business debt?
If you are asking yourself this question, you most likely should pursue debt consolidation, debt reduction, debt relief, or some other debt restructuring. An improper debt stack is an expensive – if not fatal – business mistake. Signs you should restructure business debt include:
- Paying interest rates in excess of 10% APR.
- Paying “% fees” instead of APR interest.
- Debt repayment on daily or weekly intervals.
- Debt repayment as a percentage of revenue received.
- Owing money to 3 or more different lenders.
- Loan terms of less than 1 year.
- Difficulty making routine debt payments.
- Taking on new business debts to pay old business debts.
- Profitable operating income, but net losses driven by interest expense.
If you are experiencing any of the above symptoms, contact a turnaround CFO before it is too late. Our professional debt restructuring has helped businesses from all different industries by negotiating with lenders, pulling liquidity levers, and restructuring companies to avoid bankruptcy. Schedule your free consultation now.