Why (and How) to Grow Your Service Company Debt-Free Bigger is not necessarily better. Debt-free and profitable is better.
By Mike Barrett Edited by Dan Bova
Opinions expressed by Entrepreneur contributors are their own.
The truth is, there's zero reason to take on debt if you start and grow a service company. Yes, even if you want to grow fast. Early on when launching my own business, I made the mistake of thinking some debt would be good, manageable and helpful when cash is needed for fast growth. Like many other entrepreneurs, I wanted a fast-growing company. I wanted to drive it like I stole it. For a small services company, it's akin to giving a high-limit credit card to a teenager: It's not a great idea and will usually end in conflict.
Related: Debt vs. Equity Financing: Which Way Should Your Business Go?
Bankers told me that a line of credit would be a good thing -- a smart thing that smart business people get to help them grow a company. They weren't telling the truth. OnDeck, LendingTree and other lenders like them don't care if you're a service-based company; they want the loan business regardless. They'll give you debt-laden handcuffs that you'll regret later. Some of these small business lenders take the payments directly from your business checking account, leaving you with no payment flexibility. They get paid first and the interest rates can be high. Also, you'll have to personally guarantee these small business loans. Meaning that if your small business fails to pay, the lenders have the right to collect from you, personally and legally. That money will come out of your personal checking account.
Some types of businesses need access to lots of cash in order to grow. Debt, equity or mezzanine financing is critical for those companies to survive. It's true for capital-intensive manufacturing companies, and for software- and hardware-based companies that need to hire large teams of engineers for years before any money can be made. The most obvious example of this is Amazon, which raised a universe full of money and took years to make a profit. For "unicorn," once-in-a-lifetime companies like Amazon or Facebook, that strategy works.
At a large scale, when a service business wants to make acquisitions or go public there might be a solid reason for some debt. There are various kinds of debt vehicles and various kinds of equity vehicles that can help accelerate your growth. Not all debt is evil; some types of low interest debt might be a good idea in some cases. But, in my opinion, your company would have to generate more than $50 million in revenue for this to make any sense.
Related: 4 Reasons Why Borrowing Money Is Usually Better Than Giving Up Equity
For example, let's say there is a unique opportunity to acquire a competitor. If that opportunity arises, taking on a small amount of affordable debt might be a wise choice. But, even then I would avoid it if possible. When a service business is large and growing, the cash peddlers come out of the woodwork. Don't succumb too easily. It can be a long-term bear trap.
Bigger is not necessarily better. Debt-free and profitable is better.
We started our service company with a set of rules that have served us very well over the years. One of them being, don't go into debt with anyone! For any reason! The results? Our company started 8.5 years ago with three employees and today has almost 400 employees and is one of Oregon's fastest-growing companies. All that without any debt and staying profitable the entire time.
By following a few simple rules, you can grow your service company. Here are a few that we used that you should consider when launching your service company.
1.Focus on gross margin.
Revenue does not matter; only gross margin matters. So pick customers that provide you with a healthy gross margin, and fire the customers and ignore the prospects that drive your margins down.
Related: Debt Is the Tiger That Will Eat Your Company
2.Set up how you'll use your gross margin dollars by ratios and never violate them.
For example, we never spend more than 30 percent of gross margin on overhead. Profit distributions are closely guarded as well. If we have at least 40 percent year-over-year growth, and if we have at least a 40 percent gross margin, and if we have at least a 10 percent net profit margin, then we can distribute cash to shareholders. We do it this way because we need as much cash in the business to fund growth. We don't just distribute profit loose and free.
Find the model that works for your business and don't bend the rules. Build up your business so that you're the lender someday and not always the borrower. Now go drive it like you stole it!
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