Reflection Seven

In Chapters 11 and 12, Rao expands on two more strategies that finance-smart entrepreneurs use: seeking scalable debt and choosing smarter instruments.

Rao explains that some loans grow with your business as they are automatically refinanced as asset levels increase, so his advice is to seek loans that can grow with the business.

Types of scalable debt Rao points out are as follows:

*line of credit (usually from a bank)

*transaction loan (short-term loan)

*leases (used to finance fixed assets such as equipment and real estate; leasing can help you expand faster and improve cash flow); Dick Schulze (Best Buy) and Sam Walton (Walmart) built their businesses by leasing—leasing allowed them to grow faster and dominate the market

*trade credit (usually the “cheapest” form of financing; cost is built into the price of the products or services you purchase

*customer advances (can be done by selling directly to consumers)

Rao points out that getting advances from customers is one of the best sources of funding for entrepreneurs because they are part of the value-adding chain.

Sources of Scalable Debt that Rao mentions:

*asset-based lenders (flexible financing; usually going to charge higher interest rate because of risk of business and the lender’s monitoring; involving your bank reduces your cost)

*commercial banks (lower interest rates; may offer revolving lines of credit; this is often the best source for entrepreneurs that are good candidates to receive financing from angels to VCs

*sales finance companies (directly to consumers or via retailers who originate the loans)

*leasing companies (allows a business to use equipment without a down payment

*factoring companies (buy accounts receivable from businesses)

*internal based lending (help stronger, small to mid-sized businesses with funding)

*development financiers (offered to businesses that can grow and that create jobs)

A key point Rao makes: to use scalable debt, you need cash flow to repay interest and principal.

Rao says each instrument (equity, hybrid, debt, leasing) has its own use, cost, risk, and method of repayment.

In looking at the equity and hybrid instruments (common stock, preferred stock, convertible debt, warrants, franchising a way to get equity, and employee stock ownership trusts-ESOPs), the following, Rao describes, apply:

*most expensive in regards to dilution and risk of losing control

*require a share in the company (immediate ownership) or the right to buy share in the future

*reduce the risk and cost of bankruptcy

*can help entrepreneurs finance their business and stay in control

Rao says the key to using debt is to make sure the funding earns higher returns and help the company grow, while having cash flow to make payments.

Using debt for funding got me thinking about how a business owner, especially starting out, could possibly think they don’t want to go in debt, but that if they knew how they could use debt to their advantage, they could then feel less apprehensive about it and realize it could be key to helping with success.

According to Capstone Partners (2024), some advantages of debt financing are

• Lender has no control over the business’ operation.
• Prevents ownership dilution.
• Interest paid on debt is tax-deductible in most situations.
• Offers flexible alternatives for collateral and repayment options.

 

Would you consider debt financing?  Why or why not?

References:

Capstone Partners (2024). Advantages and Disadvantages of Debt Financing. Capstone Capital Markets, LLC.

Rao, D. (2020). Finance Secrets of Billion-Dollar Entrepreneurs: Venture Finance without Venture Capital. FIU Business Press, Mango Publishing Group.