By Mark Zepezauer
‘We’ve almost never had enough capital.”
Jim Garrett Jr., who owns AquaPure Hydration, 3200 S. Dodge Ave., with his wife, Amy, tells a tale familiar to business owners.
“It seems like our business has always needed a dollar more than what we came up with. It’s always been a challenge. A small, fast-growing business presents a lot of challenges.”
But the Garretts have survived 11 years in business, mostly by borrowing what they needed.
Cash flow is the struggle for Dan Justice, vice president at R.E. Barnett & Sons Trucking Co.
“It’s not so much that you’re not making the money, it’s just that you don’t have your cash readily at hand,” he explained. “You get paid slower than you have to pay your bills. We learned that one the hard way, and that’s a struggle, obviously. It’s very stressful.
“You’ve got people depending on you for a paycheck. You’ve got people depending on you for your bills that you owe. And it was just a miscalculation, and it puts you and your family at stress.”
But Barnett Trucking has grown from one truck, back in 1983, to a fleet of 40.
Borrowing money can help a business stay afloat, but it can be a dangerous proposition. The debt needs to be structured correctly, and for the right amount, in order to produce the needed outcome.
There are two basic varieties of loans: debt financing and equity financing. Sources of equity financing can include private investors, venture capital firms or even international investors. Firms can also consider going the route of merging with a more established company, or seeking a strategic investment from a larger firm that runs its own venture capital division.
In terms of debt financing, commercial banks are the obvious, but not the only source.
Commercial finance companies may charge higher rates, and are thus more willing to take some risk. They may offer discounts if you take advantage of some of their other services, such as payroll or accounts-receivable management. Leasing is also an option if firms are unable to borrow enough to purchase new equipment.
Both debt and equity financing options have their pros and cons.
“Obviously with equity, you’re giving up ownership of the company, or some ownership of the company,” explained Tom Fraker, executive director of the Arizona Small Business Association. “You are then accountable to that investor. And it’s, in many cases, much harder to determine what that value is, especially if you’re a small company.”
But equity financing has its advantages, as well. One is that “you’re paying out of future earnings, and not out of cash flow,” Fraker said.
“You improve your ability to borrow money in the future because you’re recapitalizing the company and getting a better debt-to-equity ratio. You’ve partnered, in many cases, with somebody that perhaps has astute business knowledge, and advice for you, that can help you grow your company, based on what they would contribute – outside of money.”
In the end, having complete control was more important to Jim Garrett and his wife.
“We had partners when we first started out, and ran into some problems with those partners and wound up having to buy them out, and had to go to the bank to buy them out,” Garrett said. “So we’ve gone through a number of rounds of seeking financing, and doing a variety of things to get financing for expanding our business.”
And that meant going the debt financing route.
“With debt,” explained Fraker, “you’re going to have to pay that before you pay yourself, so it’s coming out of the first dollars earned. It sometimes has restrictive covenants on it, what you can do with your company, relative to financing other assets that you might have.
“And you become something of a speculator on interest rates. You know, rates move a lot, and you could conceivably borrow at a time when rates are high, and then rates go lower. And some loans have covenants that you can’t refinance after a certain period of time.”
“The upside,” Fraker added, “is that you haven’t given up any ownership in your company, which most entrepreneurs would love, that they don’t have to answer to anybody other than themselves, or perhaps their dog.”
State and local governments also offer direct loans and loan guarantee programs to help foster economic development.
Melissa Amado is community development director for the Tucson-based Business Development Finance Corp., a nonprofit. It began in 1979 as part of the city government and later spun off into the private sector.
“We always like to see jobs added for the simple reason that it’s building our economy,” said Amado, one of Tucson Business Edge’s 40 Under 40.
“One of our great success stories would really have to be our revolving loan fund. In 1981, the City of Tucson allocated to our office $100,000 to create a revolving loan fund. The premise was to loan the money out, charge a nominal interest rate, and get it out into the business community. To date we’ve done over $18 million within Tucson city limits.”
“Something that always surprises me,” Amado said, “is that business owners cannot differentiate between a loan versus a revolving line of credit. A loan is designed primarily for purchasing fixed assets. A revolving line of credit is a quick fix: they need to make payroll. And banks are the ones that are able to provide those revolving lines of credit. Hopefully it’s a one-time issue, and then they pay it off at the end of the month, and then they don’t owe anything.”
How does a business owner know how much to borrow?
Heath Bolin, who bought the Sparkle Cleaners chain five years ago, has a rule of thumb: “Whatever you think is a good deal, you should add at least 25 percent to that, in your favor, and then it may be a good deal.”
Jim Garrett has his own guidelines: “Add up all the money that you think you’re going to need as a worst-case scenario and then double that. And that’ll probably be a realistic figure to work from.”
Dan Justice takes it a step further: “Expect your expenses to be about three times what you projected. Just expect that to happen. Then if there’s a cushion, you’re happy, instead of disappointed and strangling.”
But according to Amado, it is possible to be overcapitalized.
“This what I tell people: ‘What are your true costs going to be for a startup? If you want to borrow a quarter-million dollars, let’s say your true costs to open the doors are $100,000. What are you going to do with that other $150,000?’
“Remember, this is a loan,” Amado said. “You have to repay that money ever month, with interest. Say the interest rate is 7 1/2 percent. You’re going to have to repay on that entire $250,000 while you park $150,000 in the bank.
“And what are you going to be earning at the bank because you just parked that money there? One percent interest? That means that you’re now losing 6 1/2 percent per month. You’re borrowing more than you truly need.”
Conversely, there is the danger of borrowing too little.
“We get a lot of businesses that start out thinking that maybe they don’t need to go out and borrow money,” said Nick LaPeruta, vice president of Business Capital and Consulting LLC. “And we’re telling people that maybe that’s the best time to do it, when you can qualify.
“You know the old saying, you don’t buy insurance when the house is burning. It’s not a bad idea to maybe borrow some money and start establishing some business credit, and preserve some of the capital you do have, going into the business.”
5 C’s of credit
As explained by Melissa Amado of BDFC:
One of the things that I like to hand out to the business owner is what is known as the five C’s of credit. And it oftentimes will force a business owner to stop and think.
* Credit history and management experience is part of Character. If you’re starting a business, do you know that industry? If you don’t know that industry, then why don’t you spend some time learning as an employee, rather than a business owner? From the lending perspective, we’re looking for the sense that there is potential, that the owners knows what they’re doing. From the credit history, we’re trying to capture whether or not they’ve been able to repay it in the past.
* We then look at the next C, which is Capacity. If it’s an established business, is the cash flowing positively? Or if it’s a startup, what do those projections look like? Whether those projections meet the market or not.
* And in that case, the third C: What are the Conditions of the marketplace? Is there always going to be the demand for that notorious widget or not?
* Then we take into account the fourth C, the Capital; the debt servicing requirements for that business. And then what about personally; what happens if there’s no secondary source of payment for that household? Will it go under as well, if that business goes under?
* And finally the fifth C is the Collateral. Does the business have sufficient assets to pay back the lender or investor? It all comes down to cash flow and collateral. Collateral is always required to be sufficient to pay the debt of the loan.
And then taking into account those five C’s, it kind of puts the person into a sense of, “Well, yes, it’s a little bit intimidating, granted. But it’s better to ask those questions ahead of time, than to spend your life’s fortune.”
The financing formula
Tom Fraker explains the financing formula:
“For most small-business owners, there’s the 3-F rule, that you raise money from friends, family and fools to get your business started.
Once they build their business, they want to pay all those people back, so they think they can borrow based on the value of their company. And so if you are conservatively placed in the marketplace – and these numbers run the gamut – something in the area of 50 percent equity and 50 percent debt, that would be a good ratio.
If you’re a proven second-stage company, you could switch that ratio to maybe 60 percent debt and 40 percent equity. And if you’re a company that’s been around for five-plus years, have maybe $25 million, $35 million, or $50 million a year in sales, you could probably go to 80-20; 80 percent debt to 20 percent equity.”