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Debt End Ahead?

Don't let debt put your business in a tight spot--learn how to use leverage to your advantage.
July 1, 2004
URL: http://www.entrepreneur.com/article/71404

The ancient Greek mathematician Archimedes once said that with enough leverage, he could move the entire world-if he only had a place to stand. Like Archimedes, some entrepreneurs seem to believe that with enough financial leverage-a euphemism for debt-the moon and stars will align, and their business success will be assured. But like Archimedes, those same entrepreneurs are often left without a place to stand.

To be sure, some succeed. Mike O'Brien pledged his own home, his brother's home and more when he needed to cover more than $1 million in organizational costs for his third business, FinancialAid.com. And Seth Frey racked up six figures of personally guaranteed debt as he built a million-dollar mail order business called Granny's Goodies.

For companies not backed by the deep pockets of VCs (and that's the vast majority), leveraging family homes, credit cards and personal guarantees may seem like a panacea for all kinds of business problems. It may also seem like the beginning of a whole lot of trouble.

O'Brien, 33, says he'd do it all over again. His million-dollar gamble laid the foundation for San Diego-based FinancialAid.com, which made $18 million in 2003 by helping college students and their families find free money for college, and by extending loans to them. But for Frey, taking on debt created more challenges than it resolved.

Moving Up

Frey, now 33, and his younger brother started selling gift baskets and promotional items to corporate clients from their mother's basement when they were in their early twenties. Granny's Goodies enjoyed the low overhead of a basement business and the high energy of two young entrepreneurs. When sales started to climb, the brothers climbed out of the basement and used an SBA loan to rent an office.

As strong sales continued, so did the company's appetite for debt. One loan led to another. By mid-2000, Granny's Goodies had sales of nearly $1.4 million-and debt of more than $250,000. Frey's loans were a mixed bag of SBA notes, accounts receivable factoring, credit cards and loans from family. And of course, both of the Frey brothers were personally guaranteeing each note.

Ever optimistic and forward-looking, Frey says he didn't plan for repaying the debts with interest. "Because the systems weren't there to help us get out of debt," he says, "it got to a point where we were trying to manage the business [operations] and the debt; and we lost focus on sales."

Frey admits that they took on debt without even planning what it would be used for or how much return it would generate. As a result, Granny's Goodies grew fast; but the debts grew faster. The combination of growth and heavy debt loads exposed every weakness in the company's finance and operating procedures.

"We didn't have the systems and processes to maintain control, which led to a litany of issues between my brother and me," laments the older Frey. "Unfortunately, the debt brought the business down. It was overwhelming because we weren't using it for the right purposes, and we burned through it."

In retrospect, Frey says he learned an important lesson. "Debt is challenging," he says. "You've got to be smart about using the money you receive and have a plan for using it, or you'll just dig yourself into a hole."

In addition to a plan, it's important to use the right kind of debt. Short-term, working-capital loans-like the kind Frey was using-typically carry a high interest rate and should be used only to cover short-term cash needs. Instead, Granny's Goodies was leaning on these notes to open new offices and expand into new product lines, which created a need for more cash.

Maintain Balance

There's no doubt that using credit is an important part of growing a company. Credit cards and lines of credit, even those with relatively high rates, can provide the cash-flow tools that business owners need to grease the wheels.

"It's common for small businesses to finance their very early stages through credit cards," says Jean Burkhart, vice president of Visa business products for Visa USA Inc. She explains that more and more business owners are leaning on credit cards these days. According to Burkhart, Visa estimates that roughly two-thirds of all business purchases made with plastic are still put on personal credit cards. "Some of the fastest growth areas are rent, advertising and marketing," she says, noting that the number of small-business credit card transactions grew by 29 percent last year for Visa.

Burkhart says credit card companies provide tools that help business owners avoid overextending themselves. Visa, for one, offers several online account management tools, including some that pay bills automatically, track changes in spending, and integrate with other small-business software.

Don't Be a Statistic

Far too many business owners who don't manage credit carefully plunge into debt and end up in over their heads. During 2003, for example, more than 4 percent of U.S. credit card accounts were delinquent, with another 5 percent charged off and considered uncollectable, according to the Federal Reserve. In addition, more than 35,037 businesses declared bankruptcy during 2003, according to figures compiled from court records by the American Bankruptcy Institute.

Since small-business owners often use their personal credit cards for business purposes, it's hard to pinpoint trends exactly. (For a closer look at some theories about credit and bankruptcy, see "Down and Out").

Through mounting debt and tough economic times, Granny's Goodies avoided the worst. The core business survived intact, but the Frey brothers' partnership did not. The debt eventually caused so much tension between the brothers that they decided to work apart. They split the customers, the assets and the debts as fairly as they could. Each decided to re-brand his own operations and focus more on strong profits and slow growth. The new Big Frey Promotional Products is off to a great start in the John Hancock building in Chicago. Frey sums up the experience with an easy smile: "I've heard from others that slow and steady wins the race every time. Now I plan the work and work the plan."

Crazy Like a Fox
Despite what you may think, debt is not a four-letter word. Used properly and judiciously, debt is an important business tool. "But be careful how much money you risk and how much you borrow. Set a limit for yourself so you know when you should get out," says Barry Moltz, a serial entrepreneur, angel investor and business coach. "How much can you afford to lose and still live to prosper another day?"

Most important is how the money is going to be used. Moltz advises, "If it is funding additional capital equipment, inventory or other investments necessary to grow the business, it might be a good risk. If the money is just funding operational losses, think again."

In his book You Need to Be a Little Crazy: The Truth About Starting and Growing Your Business (Dearborn Trade Publishing), Moltz chronicles the ups and downs of running his own businesses, including how he lost $25,000 borrowed from a friend-and then lost the friend.

For Moltz, borrowing is just one aspect of being a "crazy" entrepreneur. His new book is a fun, provocative and somehow comforting look at the trials and tribulations of starting and running a business.


David Worrell is author of the e-book Finding Funding. Contact him at .