I remember sitting in a second year class at business school call Acquisitions of Closely Held Enterprises. The guest speaker was an expert in leveraged buyouts (LBOs). He stood at the whiteboard and wrote something on the board that went like this:
BUY COMPANY AT 2.5x FCF.
20% EQUITY, 80% DEBT
SERVICE DEBT IN 4 YEARS
SELL COMPANY FOR 2.5x FCF
ROI = ?
The answer was 400% return on investment. After all, you’re letting the bank put in 80% of the investment, and once you take the bank out of the equation, it’s all yours. Gravy. Easy money. This speaker had done it several times. Buy company. Leverage to hilt. Service debt. Sell company. Lather, rinse, repeat. Ah, the magic of math. It makes everything sound so easy.
As I drove to the bank to pull out money from our joint savings account to cover payroll and to cover the payment on our tapped out line of credit, I remembered that guy and his @#!&$ equation on the white board. I was waking up in the middle of the night wondering what we’d have to do to keep going and if we really would be able to service the debt with our receivables (note: don’t borrow against yourself unless you have the receivables to cover it).
When everything goes to plan, leverage can be your friend, as other people’s money (OPM) allows you much greater financial reach. When you use OPM, you can buy things that you might not otherwise have been able to do. When you’re using OPM to buy an appreciating asset, then the leverage works out in your favor.
But no one in business school wants to talk about the other side of the coin. They don’t talk about what goes wrong in leverage. Let me cover a few of the downsides of leverage.
You’re personally signed for the loan. No bank is going to take a green-behind-the-ears entrepreneur on his word and loan him a bunch of money only using the EIN or the DUNS for creditworthiness. No. You are going to personally guarantee that loan, and if you don’t pay it back, they’re coming after all of your assets. Hope you’re ready for it.
Leverage allows you to be sloppy. Because you have extra cash that you didn’t generate somehow, you’re sloppy with it.
Few people have rigorous discipline to streamline the organization to knock out the debt. Instead, they do like we did, and pay the minimum payments and occasionally pay when there’s extra and nothing “better” to spend the money on. Our line of credit hung around needlessly for years. We treated it like a pet that we didn’t want to get rid of.
The depletion of your free cash flow means that you can’t reinvest or give more to your employees. Instead of investing in incremental marketing to drive more revenues or paying more in bonuses, we were servicing debt.
Debt makes dissolution more complicated. If you have to shut down shop, you can’t just wish away that debt. The bank is a vendor, and they’re in first position. The debt also might make you try to hang on when you should have given up, causing a vicious cycle.
Debt creates a psychic cost on the signatories. Even if you’re confident it will be paid off, you’ve created a tumor in the back of your brain that doesn’t go away until the last payment is made. It affects your decision-making. You always have to keep debt servicing foremost in mind, or the bank will help you to do so. It changes how you do business.
Start out from day one with no debt, and your company will run much more smoothly. If you’re buying an existing business, structure an owner finance deal with the profits of the company, or a percentage of the revenues if your margins are high enough.
The math might work for leverage, but math never accounts for stress and worry.