Debt, when used properly, can be just the ticket for jump starting your business or helping you make it through tough times. The purpose of this article is to provide a general understanding of the most common types of debt at your disposal and to help you know how and when to use them. Our discussion continues by covering the topics of leases, bank loans and lines of credit.
Leases
Leases are typically used to acquire the use of furniture and equipment, but are often used to buy all kinds of tangible property. Mindful has clients who have leased software, equipment service agreements, computer hardware, phone systems and buildings.
Non bank entities are usually the easiest to work with. Leasing companies and equipment vendors usually have less stringent lending requirements. Their goal is to sell as much “stuff” as they can. Not that they aren’t concerned about your ability to pay the lease. They just take a different view of things than a bank. Depending upon the amount you plan to spend you may not, for example, be asked to provide copies of tax returns or financial statements.
There are two types of leases: operating and capital. When you enter into an operating lease you “rent” the equipment for the lease period. At the end of the lease you have the choice of keeping the equipment and entering into another lease period, returning the equipment or entering into another lease period with new equipment.
Capital leases are an alternative method of financing the purchase of equipment. At the end of the term, after making a minimal final payment you own the equipment. You’ve probably heard the term “$1 buyout”. This is where it comes from.
Leases are best used when you lack the money to make a down payment, when the item in question needs to be replaced frequently or when cash flow is an issue. Leases usually require a deposit be made, but don’t require the 10%-20% down payment of a loan. Payments under an operating lease always are less than what you would pay under a traditional loan.
Bank Loan
Although the down economy may seem to suggest the opposite, banks are in the business of lending money. They love giving loans to small businesses. The trouble is that banks almost always require collateral. Unless your business is doing well and owns valuable assets (equipment, real estate, investments, inventory or accounts receivable) or you have personal wealth you are willing to put on the line for your business, banks will not loan to you. Also, do not turn to banks if your personal credit score is less than good. Loans usually require a down payment of 10% - 30% of the purchase price. For a small business or a start-up, this requirement can put a loan out of reach.
All of the above being said, banks are the “go to” guy when a large amount of money is needed and your business is healthy. Approaching a bank for a loan is easier after you have established a strong relationship. Even the largest, most impersonal banks are more willing to loan money and give more favorable terms if you have been a good customer for a period of time.
Line of Credit
Lines of credit are designed to provide short-term infusions of cash. Typically, you may draw against your line at any time for any amount up to your credit limit. In the past, no particular repayment schedule was required. Recent changes to credit practices have resulted in most line requiring that at least a minimum payment be made each month. The monthly payment is usually far lower than the amount you would have had to pay if the amount was borrowed as a formal loan.
There is an art to using a line of credit. Banks (the most common issuer of lines of credit) prefer that you use the line at least occasionally and that you quickly pay off the balance. To them this represents a responsible use of credit and it makes them feel more comfortable about having granted you what is essentially an open ended loan. Beware of the wrong use. Business that quickly withdraw funds up to their credit limit and are slow to make payments may soon find their line of credit terminated and their outstanding balance converted to loan with required monthly payments. Once this happens, your line will likely never be re-instated.
A line of credit is the debt tool of choice to: weather cyclical business changes, fund purchases of equipment that can be quickly paid off, keep cash flowing until payment is received on a past due invoice, fund business growth when lower cost options are not available.
There you have it, the most common forms of debt you are likely to use in your business. Remember, a responsible use of debt can provide the capital needed to grow your business. A poor use of debt will act like a lead weight around your business’s neck. Too much debt or debt used at the wrong time in the wrong amount will stifle growth and could result in business failure.
Please call Steve Breitman at 303-359-1964 to answer your questions about creating a debt strategy for your business.
