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Affordable Debt: The Better Angel to Fuel Growth

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Small businesses continually ask "To be or not to be" questions. What business should you be in? Should you continue to be or stop? And should you be in debt or not? The traditional route is to invest your own money, then friends and family's money, then angel investors' money along the way towards an IPO. At some point, debt comes into play. Done right it creates and preserves longer-term wealth. Done poorly and the "To be or not to be" questions become moot.

As Merchant Cash and Capital's (MCC) CEO Stephen Sheinbaum explained to me, echoing voices we've all heard forever, "Debt is cheaper than equity - assuming you can afford it." He cites the example of a Subway franchisee who spends $200K to buy two franchises. They do well and he goes to buy a third. He considers a partner who would invest $100K for a 50/50 ownership. Instead the franchisee borrows the money. At the end of two years, he's paid back the principal and an incremental $30-40k in interest and retained 100% of the equity. The trade off is between selling half the business for $100K or paying $30-40K to keep the whole thing.

Those of you that can multiply have figured out that $30-40k over two years on a $100k loan is 15-20% interest - well above current prime rates. That's because the Subway franchisee in our example is not going to get a loan at prime. Actually, he's probably not going to get a bank loan at all. And, if he does, it's going to take months because he's small, hasn't been in business all that long, has virtually no collateral and doesn't want to personally guarantee the loan. Sheinbaum started MCC to serve the funding needs of businesses having a hard time accessing traditional sources of capital.

Essentially, MCC purchases future revenues at a discount, taking a cut of the revenue that goes through its customers' credit card processors or business bank accounts until the balance is repaid. It's akin to factoring. They charge more than traditional banks, but less than credit cards or angel investors. They are not a permanent solution. Instead they "prepare people to graduate to traditional bank debt".

Debt = Leverage

Two recurring dreams that many entrepreneurs have is to "make money while they sleep" and to leverage "other peoples' money". The scary thing about other peoples' money is that some of those other people care about their money and want a say in how it's used. There's a real cost to leveraging other peoples' money. On the non-monetary side the cost is giving up at least some control. On the monetary side it may be more expensive than debt over the long term as we saw in the Subway example.

Certainly some entrepreneurs pride themselves in not having debt. Debt is leverage. When things are going well, it has a positive multiplier effect on value creation. When things are going the other direction, it has a multiplier effect on value destruction turning "making money while they sleep" into "losing money while they sleep". There's no question that debt-free entrepreneurs sleep better. Those looking for relative stability are generally better off minimizing their debt.

Those looking to grow need to fuel that growth. At some point this requires cash. The choice is whether to fuel growth out of the cash from operations or an infusion of cash from your own pockets, someone else's pockets, or some sort of debt. I'm not arguing that debt is the answer. And I'm certainly not arguing that higher-interest debt is the answer. I'm just suggesting that entrepreneurs looking to grow should consider different alternates to fuel that growth.

Fueling growth alternates:
  • Cash from operations
  • Loans from banks, factors, credit cards, sharks
  • Equity sales to friends, families, angels, venture capitalists, private equity, public markets

This article originally appeared on Forbes.com