Whether a small loan from family or friends at the start or a sophisticated term loan and operating line of credit from a regional commercial lender, most companies borrow some amount of capital along their path to growth.
The use of debt in the capital structure, which is called “leverage,” affects both your company’s valuation and the overall cost of capital. The proper debt-to-equity ratio for your growing business depends upon a variety of factors, including the following:
The impact your obligation to make payments under the loan has on the cash flow of your business.
The costs and expenses relating to obtaining the capital.
Your need for flexibility in the capital structure to be able to respond to changing economic or market conditions.
Your ability to get access to alternative sources of financing.
The nature and extent of your company’s assets, both tangible and intangible, that are available to serve as collateral to secure the loan.
The level of dilution of ownership and control your shareholders and managers are willing to tolerate.
Certain tax considerations – for example, interest payments are a deductible expense while dividends are not.
Managing Risk
The maximum debt capacity that a smaller growing company will ultimately be able to handle usually involves balancing the costs and risks of defaulting on a loan against the owner’s and managers’ desire to maintain control. Many entrepreneurs want to maintain control over their company’s governance, so they’ll take on the higher level of risk inherent in taking on additional debt obligations. A company’s ability to make payments must be carefully considered in its financial projections. Another major 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 cash flow crunch, because you lose your negotiating leverage and weaken your company’s financial position – all of which is a major turn-off to most lenders.
Minimizing and managing risk has a direct result on the attractiveness and affordability of traditional debt financing. For a small, growing company, this means a loan proposal package that demonstrates the presence of a strong management team; an aggressive internal control and accounts receivable management program; financial statements and projections that demonstrate the ability to meet repayment obligations; solid relationships with suppliers, distributors and employees; and an understanding of industry trends. In addition, many commercial loan officers apply a traditional test known as the four “C’s” of creditworthiness. These include character(reputation and honesty); capacity (business acumen and experience);capital (ability to meet debt-service payments); and collateral (access to assets that can be liquidated in the event of a default).
Loan officers assess all of these elements to determine your credit-worthiness and the relative risk to the bank in making the proposed loan. Loan officers also assess whether your company and proposal present an opportunity to build a long-term banking relationship, in which you will eventually need additional services and larger loans from the bank. Be sure to help the loan officer understand your long-term needs, as well as your desire to build a relationship with the lender.