Below is an excerpt regarding understanding your borrowing options from Andrew J. Sherman’s book “Build Fast Build Right, 12 Strategies To Continue Building On Your Success.” Andrew J. Sherman is a partner at Jones Day in the Washington, DC office ([email protected]) and focuses his practice on issues affecting business growth for companies at all stages, including developing strategies to leverage intellectual property and technology assets, as well as international corporate transactional and franchising matters. He has served as a legal and strategic advisor to dozens of Fortune 500 companies and hundreds of emerging growth companies. For more of his work, visit his page here.
Understanding Your Borrowing Options
No Sophpreneur™-owned company survives and prospers without some debt component on its balance sheet. Whether it's a small loan from family and friends or a sophisticated term loan and operating line of credit from a regional commercial lender, most Sophpreneurial™ companies borrow some amount of capital along their path to growth. The use of debt in the capital structure (which is commonly known as leverage) will affect both your company's valuation and the overall cost of capital. The proper debt-to-equity ration for our business will depend on a wide variety of factors, including:
- the impact that your obligation to make payments under the loan will have on the cash flow of your business;
- your costs relating to retaining the capital;
- your need for flexibility in the capital structure so you can respond to changing economic or market conditions;
- your access to alternative sources of financing;
- the nature and extent of your company's assets (tangible or intangible) that are available as collateral;
- the level of dilution of ownership and control that our shareholders (and managers) are willing to tolerate; and
- certain tax considerations (interest payments are a deductible expense, but dividends are not).
The maximum debt capacity that a small growing company will ultimately be able to handle will usually involve balancing the costs and risks of defaulting on a loan against the owners' and managers' desire to maintain control. Many entrepreneurs want to maintain control over their company's affairs, so they'll accept the risk inherent in taking on additional debt, rather than ceding some decision-making power to outside investors. Your ability to make payments must be carefully considered in the company's financial projections. Another key issue in debt financing is timing. It is critical to start the process of looking for debt capital early and not wait until you are in a real cash-flow crunch, because you will lose your negotiating leverage and weaken your company's financial position-a major turn-off to most lenders. If your business plan and cash-flow projections reveal that making loan payments will strain your company's financial condition (or that you don't have sufficient collateral), then you should explore equity alternatives. It's simply not worth driving your company into bankruptcy solely to maintain maximum ownership and control. Remember the saying, 60 percent of something is worth a whole lot more than 100 percent of nothing.
You should also compare the level of debt financing you are planning to obtain against the typical rations for businesses in your industry (such as those published by Robert Morris Associates or Dun & Bradstreet). Once you've figured out your optimum debt-to-equity ratio, you can look into the sources of debt financing, and the business and legal issues involved in borrowing funds from a commercial lender.
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