Debt and Liability Management: Key Issues and Considerations for Entrepreneurs

Greg Sarian of the Sarian Group at Hightower shares his advice on Debt and Liability Management with Key Issues and Considerations for Entrepreneurs

When launching and growing a company, entrepreneurs should anticipate that the entity will experience a full life cycle. Often, entrepreneurs will encounter cash flow, business development and human capital challenges within the first several years of operation. As the entity matures and becomes stable, the consistency of revenue affords the opportunity to build increased enterprise value and perhaps diversify revenue streams. In the later stages of a company’s glide path, the focus may turn to increasing EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), and ultimately, preparing and positioning the business for an event.

Throughout the business’s life cycle, the entrepreneur/owner’s personal financial status evolves as well, given that the typical entrepreneur is heavily invested in his or her business. To help maintain the strongest personal financial position possible, it is critical for the entrepreneur to have a strategy for managing debt during the business life cycle.

In those earlier years, when attracting capital is most challenging, understanding the distinction between good debt and bad debt is very important. As a rule of thumb, the type of financing that is the easiest to secure can often be the least advantageous from an income tax and cost-of-borrowing perspective. Examples of less attractive debt include credit card debt, consumer loans, 401(k) loans and borrowing from life insurance policies. Generally, consumers are charged a higher cost of capital, and the interest on credit facilities is not tax deductible, so the entrepreneur experiences the full cost of borrowing.

Alternatively, entrepreneurs seeking the flexibility of personal credit facilities to fund their businesses often have options, such as a home equity line of credit. Typically, if the mortgage balance is less than 80 percent of the fair market value of the home, it’s possible to take out a second line of credit on that equity. Up to $100k of usage interest cost is deductible.

Often, entrepreneurs find themselves needing to raise short-term capital, even if they are waiting for an investment or receivable. A margin loan may provide a liquidity solution for short-term capital needs. A margin loan is a variable rate loan that can be utilized by collateralizing equity in an entrepreneur’s non-retirement investment accounts. Typically, a business owner can borrow up to 50% of the value of his or her non-retirement investment portfolios. The interest on the outstanding balance is also tax deductible against net taxable investment income. This is not a long-term solution, due to the variable rate of the loan and the fact that securities can fluctuate based on the financial markets.

Regardless of the tactic, entrepreneurs should also consider the duration and variability of the cost of borrowing. Mortgage loans and fixed rate business loans tend to fix a cost of capital for a set period of time. These are highly preferable to variable rate loans because the borrowing costs are fixed and can be fit into a budget. Variable rate loans, where the cost of borrowing is a base-lending rate such as LIBOR (London InterBank Offer Rate), or the Fed funds rate plus a spread may initially be attractive, given today’s low interest rate environment. However, the direction of rates is clearly trending higher, and variable rate loans will increase as the Fed funds rate increases. Ideally, variable interest rate lending facilities should only be used for short-term borrowing needs.

Also, servicing the debt, or paying the debt off over time, should be a primary consideration before any form of debt is incurred. Whether the debt is fixed or variable, debt service should not be so significant that it hinders an entrepreneur’s ability to save, spend and give to philanthropic causes. A conservative rule of thumb is that personal debt service, including mortgage debt and consumer loans, should not exceed 35 percent of an individual’s take-home pay. This gives an entrepreneur the flexibility to increase his or her net-worth through other diversified savings and investment strategies.

When it comes to managing the liability side of a balance sheet, it is critical to determine whether it is sensible to invest or pay down debt. While the answer is often based on an entrepreneur’s personal comfort level with debt, there are some fundamental issues to consider. The first, and perhaps most straightforward, is measuring the true, after-tax benefit cost of borrowing money. If that becomes the hurdle rate, the answer is how much risk an entrepreneur needs to incur to achieve that return. If a business owner is comfortable investing at a rate to exceed the borrowing cost, it makes sense to maintain the debt. For entrepreneurs with lower levels of risk tolerance, paying down the outstanding debt may be a better course of action.

Managing the debt necessary to fund a growing business is a significant consideration for any entrepreneur leading an early- to mid-stage company. As the business matures, debt can be moved to the business entity itself to remove or reduce an entrepreneur’s personal collateral. A thoughtful exploration of what types of debt to consider, as well as a solid understanding of the pros and cons of each, can help support a better outcome for both the entrepreneur and business entity.