08 Oct Debt Restructuring
Achieving Balance in the Balance Sheet
This is another story about how money moves at different speeds. The most obvious example, perhaps, is that accounts payable move with relentless regularity, while accounts receivable often seem to amble down the road, enjoying the view. This is a key reason why businesses of all sizes need a capital resource. A business plan that is valid and viable will still have peaks and valleys, so in order to keep that business “a going concern,” it has to have means of moving forward even in the valleys. Planning and projecting those inclines and declines requires seeing ahead with some clarity, and conceiving strategies for putting time on your side.
What moves this chess game into 3-D is that the cost of money also depends on time, among other factors. And here is where the steps a business takes at the start become of critical importance later. When people start a business, they are in effect betting on themselves. The passion and insight that led them to set out independently have to be kept alive. And yet that same passion and insight often lead to overestimating their rate of return. Even the most brilliant businesses usually take longer to pay out than the founders foresee.
It is the nature of money to flow, especially when it is being managed properly. Yet the skills for managing this flow effectively over time are not very often the same skills that put you in business in the first place.
As a result, the big, commonplace factoid that people repeat is that half of new businesses fail. As usual, the details are even more telling. Forbes reported that 80% of entrepreneurs starting a business fail in the first 18 months. The results are different for different structures of business, but overall the answers are no less alarming. The Small Business Association (SBA) reports that 30% of businesses fail in the first two years; 50% in the first five years, and 66% in the first 10 years in business. From their stats, it can be expected that, overall, about one in three new businesses will still be around ten years later.
Properly structuring debt can make the difference in which side of this brutal equation your business stands on.
How They Placed Their Bets
When entrepreneurs and other business founders begin, one of the by-products of their enthusiasms – their passion and insight – is that they get money from high-priced sources. As often as not today, that means credit cards. The advantage of having buying power immediately comes with the cost of interest rates that can run in the 18% – 29% range. Perhaps just as penalizing, these are personal debts, rather than business debts. As such, the IRS has been known on occasion to challenge listing them as business expense deductions. And of course, their impact on one’s own credit rating is significant, affecting the cost of money in the future, too.
Less easy to see is how paying for assets by credit card front-loads the cost of that asset. You are paying a high rate of interest long before you get all the value from that asset. The higher-level penalty for this is that, too often, debt becomes all the entrepreneur or founders can think about, which kills the golden goose at the core of the business – their positive attitude. Restructuring business debt can make the difference between the end of a business and its future.
Matching the Cost to the Usage
An important principle for managing the “capital stack” in the balance sheet, and an essential aim for debt restructuring, is to pay for your assets at the same rate as you use them. We call this “matching maturities.” Taking a lesson from the accounting principle of amortizing equipment, good balance sheet management involves devising ways of paying for your assets at the same pace that you are using them up. The idea is to pay off the asset just as its useful life expires. This is a hard tune to play, but we know several different instruments for doing that.
The first principle is to find and negotiate business loans with an amortization curve that matches the rate of return in your business plan. A loan with too steep a curve – a three-year loan payoff for a business with a five-year payout for example, is a poor fit. This causes tension and urgency in the balance sheet, a kind of drain on financial energy.
Another way to match maturities is by leasing. In a lease, you contract to have the use of an asset for a specified period of time, at a predictable cost, without paying for the whole asset. Frequently, you also get the option to buy the rest of that asset – or not – at the end of the lease. The residual value of the asset is a part of the cost that you can accept and own, or walk away from, at the end of the lease.
A Key Factor for Success
One of the most direct ways of restructuring debt is to pay it off sooner. But how do you pay with money you haven’t taken in yet? Factoring offers an answer for paying off high-cost debt with lower-cost money. In factoring, you sell your receivables for immediate money, 70% to 90%” of value, depending on qualifications. Then, when your customer or client pays in full, you also receive that balance, less a fee paid to the factor. Factoring greatly increases the speed of money in your accounts receivable line, enabling you to reduce debt sooner, thus paying less for the money you use.
REI has the resources to call upon for effective factoring, and the experience to use it when and where it can do the most good.
Whether you’re starting a business, buying a business, or running a business, let’s talk about the difference that debt restructuring could mean for you. Get to know REI Commercial Capital, and you might see us as your on-demand CFO. Clients have depended on us for our portfolio of skills and resources so broadly that we gave it a nickname from our Fortune 500 executive suite days. We call it the 21st Floor. Call us and see how to put that big-company power in your own hands now.