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? On Business Debt, Debt Coverage, Debt/ Equity Ratio

Greg R

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When I create a thread, I typically try my best to craft it in a way to bring value to the rest of the forum. This thread is a little more self-serving than usual, but I hope that you will either learn something or be able to answer my question.

Recently in my Insider Progress Thread Buying a Construction Business and Adding Exponential Value, we have been talking a lot about the process of obtaining business loans to purchase an existing business. Something that does not get discussed much on this forum, but still has it's place.

For some of us, starting a business from scratch may not be the best option.

Maybe you are better taking something existing and adding value. Maybe you have a lot of money but are short on time. Maybe you have a family to support and have a hard time transitioning from your job because you need to maintain your lifestyle. Whatever the reason, starting something from scratch is not always the best answer.

That being said, it is important that we have a conversation about business debt.

I have some questions of my own that maybe you can help me answer.

More often than not you will probably be, or are currently using some sort of leverage in your business. If you are not, you could be missing out on opportunities to get a better ROE.

But how much debt is too much?

Does it only become too much when you are not able to pay back your lender, supplier, or family member?

Or are there guidelines to follow to make sure that you are not treading water in the danger zone?

During my research I haven't found much content on business debt. What is good vs. what is bad.

In a typical SBA loan transaction, the bank carries a note for 75%, the Seller for 15%, and the buyer for 10%. Which brings the buyer to a debt/ equity ratio of 9/1. For every dollar you have in equity, you owe 9.

When analyzing this scenario, you would think that this is an extremely over-leveraged situation.

Or is it?

For an SBA loan, banks look at the debt coverage ratio or the ability for a business to pay back a loan. They typically want to see a debt coverage of 1.2 times net profit.

If the loan payment is $80k per year, they want to see $96K in net profit.

Analyzing this from a debt coverage ratio perspective does not seem too bad.

The world of borrowing money can be confusing. It is especially less clean cut when you are doing it to make money.

Good debt is when you borrow money to make money right? I don't happen to think so. If it was "good" it would ALWAYS be good to borrow money for the purposes of making money. But it is not always good.

So here is my questions (and I no that it is not black and white).

How much business debt is too much???

I hope you are all having a great day.

Thank you.

EDIT: Math
 

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jpanarra

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When I create a thread, I typically try my best to craft it in a way to bring value to the rest of the forum. This thread is a little more self-serving than usual, but I hope that you will either learn something or be able to answer my question.

Recently in my Insider Progress Thread Buying a Construction Business and Adding Exponential Value, we have been talking a lot about the process of obtaining business loans to purchase an existing business. Something that does not get discussed much on this forum, but still has it's place.

For some of us, starting a business from scratch may not be the best option.

Maybe you are better taking something existing and adding value. Maybe you have a lot of money but are short on time. Maybe you have a family to support and have a hard time transitioning from your job because you need to maintain your lifestyle. Whatever the reason, starting something from scratch is not always the best answer.

That being said, it is important that we have a conversation about business debt.

I have some questions of my own that maybe you can help me answer.

More often than not you will probably be, or are currently using some sort of leverage in your business. If you are not, you could be missing out on opportunities to get a better ROE.

But how much debt is too much?

Does it only become too much when you are not able to pay back your lender, supplier, or family member?

Or are there guidelines to follow to make sure that you are not treading water in the danger zone?

During my research I haven't found much content on business debt. What is good vs. what is bad.

In a typical SBA loan transaction, the bank carries a note for 75%, the Seller for 15%, and the buyer for 10%. Which brings the buyer to a debt/ equity ratio of 9/1. For every dollar you have in equity, you owe 9.

When analyzing this scenario, you would think that this is an extremely over-leveraged situation.

Or is it?

For an SBA loan, banks look at the debt coverage ratio or the ability for a business to pay back a loan. They typically want to see a debt coverage of 1.2 times net profit.

If the loan payment is $80k per year, they want to see at least an additional $96K in net profit. Bringing the net profit up to $176K before the loan payment.

Analyzing this from a debt coverage ratio perspective does not seem to bad.

The world of borrowing money can be confusing. It is especially less clean cut when you are doing it to make money.

Good debt is when you borrow money to make money right? I don't happen to think so. If it was "good" it would ALWAYS be good to borrow money for the purposes of making money. But it is not always good.

So here is my questions (and I no that it is not black and white).

How much business debt is too much???

I hope you are all having a great day.

Thank you.

Awesome stuff this is the thing I really enjoyed learning about in my MBA program (don't attack me for going to school ;) ) , the biggest takeaway about debt and if you manage it properly you can negotiate with the creditors to gain more leverage, which isnt usually an issue because they want you to use more of their services to reap profits for themselves. The truth is if you have more credit and captial, the more leverage you have to put your business to an advantage.

I admit myself that I don't really have any real business debt yet. However, they did mention this issue in my MBA classes and they usually say that a company could be deemed healthy if they can maintain their debt to credit ratio around 20-40%, because that gives you more opportunities to negotiate with a creditor to give you more credit. With that increase in credit you'll be able to spend more to leverage your purchasing power against the competition.
 

Greg R

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a company could be deemed healthy if they can maintain their debt to credit ratio around 20-40%, because that gives you more opportunities to negotiate with a creditor to give you more credit. With that increase in credit you'll be able to spend more to leverage your purchasing power against the competition.

Great point!

In your case the downfall of having too much debt is that you can't get more. That sounds a little weird to say, but it if you cannot obtain any more leverage to take advantage of opportunities, you will be flat lining against your competition.

Thanks.
 

jpanarra

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Great point!

In your case the downfall of having too much debt is that you can't get more. That sounds a little weird to say, but it if you cannot obtain any more leverage to take advantage of opportunities, you will be flat lining against your competition.

Thanks.

Yeah, debt is a balancing act. If you declare to have no debt, that might be not as bad as having too much debt but your credit will suffer, and as a result, your business won't grow as quickly. Credit/Debt is a tool that can either help you build something or hurt yourself, if you don't know how to use it you'll prob lose a hand just like any other power tool.
 

ljean

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A comfortable debt level is a personal thing, there is no right answer. Some people like to borrow as much as they can, some will only deal in cash. It can make sense to borrow as much as you can when times are good, but ask anyone who lost a business or property 10 years ago during the recession what they think about debt. That is the trade off. I am a bit risk averse, a typical SBA deal with 10% equity is way too slim for my comfort level. It doesnt take much of a hiccup in the economy to go cash flow negative with that much leverage. I dont think the federal government should be subsidizing small business values in this manner, but that is another topic.
 

ljean

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By the way, your debt coverage math is wrong. A 1.2 DCR on an $80000 payment = $96,000 EBITDA
 

G-Man

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But how much debt is too much?

Depends on who's signing the PG. :clench:

Take on a minority investor and he'll want you to lever the shit outta that thing!
 

jpanarra

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But to answer your question, for me, about 50% business debt is where I am comfortable.

Thats cool, but there was a case study, I forgot which class it was, a few people did similar things but one was at like 55-60 the other one was around 40-45 and the last one was at like 30-35, and they all asked for credit increases at 3 month intervals and only the 40-45 was able to get a sizable increase every time. IDK how I'll use this information because I havent gotten any business debt yet, but maybe it'll help some ppl on here.
 

G-Man

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Having been through a decent sized corporate bankruptcy (approx 7m), and now growing a company with very limited resources, I can say the most valuable form of credit is social capital with your vendors and customers - TRUST.

Sure there are rules about being overleveraged we all remember from school, but none of that protects you in the event of a black swan (like somebody f*cks off to China with 500k in inventory, true story). Personal credibility with your customers and vendors, however, is much more flexible and robust. Think about it like building your credit score, in the course of the relationship you build credibility with those people, and in your hour of need, you may be able to "take out a loan" on it.

Maybe not the most technical answer, but it's friday, and I've been knee deep with banks and investors every day, and got no bandwidth left.

EDIT: Remember too, if you're in business and have partners, if it's your name on the paperwork, if something ever goes totally tits up and you're looking at paying back the bank, there's a 95% chance your "partners" are going to disappear into the ether. That's why it's a very personal choice, I think.
 

Greg R

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By the way, your debt coverage math is wrong. A 1.2 DCR on an $80000 payment = $96,000 EBITDA

You are correct.

Thank you for the correction.
 

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How long is the repayment of these loans typically structured? Does it vary greatly based on individual circumstances ?
 

G-Man

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I can't speak for others, but as someone who does some angel investing, I certainly don't want the companies I'm investing in to be heavily leveraged. That's not good for anyone (except maybe the bank)...
Might have been being a little facetious, although we do have one guy that has like 5% of the company that's constantly bitching about getting diluted. I think he's taking the lottery ticket approach instead of looking at it like a business
 

Greg R

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I can't speak for others, but as someone who does some angel investing, I certainly don't want the companies I'm investing in to be heavily leveraged. That's not good for anyone (except maybe the bank)...

I can see this being the case for a startup, however the company that I have a deal with right now has been around for 25 years.

Would you say that from a cash flow stand point, it is a different circumstance and can warrant the use of more leverage?

Thank you.
 

Greg R

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How long is the repayment of these loans typically structured? Does it vary greatly based on individual circumstances ?

The longest term for an SBA loan is 10 years.
 

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Greg R

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Again, I can't speak for other investors, and certainly an established company is different than a startup. But, when I invest in a company (so far, only startups), I'm looking to make a low risk investment. Unlike a venture capitalist, I'm not looking to hit home runs, and I'm not going to be happy if I lose money or break even on 9/10 deals.

Leverage creates risk, both financially and by putting stress on the principals. While there are situations where taking on debt can be smarter than raising more equity, as an investor, I'd rather an early stage company choose debt OR equity upfront, and stick with one or the other. In other words, if debt makes sense, don't raise equity; if equity makes more sense, don't raise debt.

I can see your point.

It seems crazy to me that an that the bank is willing to do a highly leverage deal even though it is back by the SBA. Maybe I am completely missing something, but I've always known banks to be more shrewd investors. I guess it could be the fact that existing businesses with 3+ years of steady cash flow have proven concepts and are thus a safer bet.
 

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The debt scenario you described is one of acquisition debt. Therefore, the most important thing isn't the debt/equity percentages of the deal, it is the debt coverage - and that is driven be the EBITDA multiple.

You indicate the SBA wants a debt coverage of 1.2.

Therefore on a $1 million acquisition that means:
- $900K debt
- $100K equity
- at 5.25% for 10 years, that is $9,656 per month or $115,872 per year
- so the SBA wants your net to be $139,046 to be 'safe'
- that gives you an EBITDA multiple of 7

Does debt payments of $115K on net of $139K look cushy?

The thing is, if you are buying a business with an EBITDA multiple of 7, you have already failed.

Your goal EBITDA should be something like 3 (there are a lot of generalizations and assumptions in that short statement.)

With an EBITDA of 3 it looks like this:
- $1 million total
- $900K down
- $333K net
- annual debt payments $115K

Does debt payments of $115K on $333K net look cushy?

Cushy enough that my goal this year is to deploy at least a million in equity in this way.

Especially given that on top of the acquisition net, I have the net from my existing businesses to help with coverage if the shit hits the fan.
 

Greg R

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The debt scenario you described is one of acquisition debt. Therefore, the most important thing isn't the debt/equity percentages of the deal, it is the debt coverage - and that is driven be the EBITDA multiple.

You indicate the SBA wants a debt coverage of 1.2.

Therefore on a $1 million acquisition that means:
- $900K debt
- $100K equity
- at 5.25% for 10 years, that is $9,656 per month or $115,872 per year
- so the SBA wants your net to be $139,046 to be 'safe'
- that gives you an EBITDA multiple of 7

Does debt payments of $115K on net of $139K look cushy?

The thing is, if you are buying a business with an EBITDA multiple of 7, you have already failed.

Your goal EBITDA should be something like 3 (there are a lot of generalizations and assumptions in that short statement.)

With an EBITDA of 3 it looks like this:
- $1 million total
- $900K down
- $333K net
- annual debt payments $115K

Does debt payments of $115K on $333K net look cushy?

Cushy enough that my goal this year is to deploy at least a million in equity in this way.

Especially given that on top of the acquisition net, I have the net from my existing businesses to help with coverage if the shit hits the fan.

Thank you for that. You should come around the forum more often. +REP

  • Debt payments of $115K on net of $139K does not look cushy at all and it is crazy to me that the SBA debt coverage requirement is only 1.11. WTF is that???
  • Debt payments of $115K on $333K is a lot better and the multiple is a lot closer to my current situation.
Right now I am looking at an EBITDA multiple of around 3.5 with 90% of the deal being goodwill. The goodwill part makes me a little hesitant because it is not really something that can be liquidated to pay off the loan.

Thanks for the reply.
 

ljean

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All SBA financing does is inflate small business prices. The first step should be negotiating the lowest purchase price you can. Step 2 is see how much of that price you can get the seller to finance via nonrecourse debt or an earn out. Lastly you should look to banks/SBA to make up the difference. If you are just looking for a business you can buy with 90% financing you are in for trouble.
 

Greg R

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All SBA financing does is inflate small business prices. The first step should be negotiating the lowest purchase price you can. Step 2 is see how much of that price you can get the seller to finance via nonrecourse debt or an earn out. Lastly you should look to banks/SBA to make up the difference. If you are just looking for a business you can buy with 90% financing you are in for trouble.

That logic is sound. Non-recourse debt can help reduce the buyer's risk and does not put him on the hook for anymore collateral than he already has.

I think the SBA's version of an earn out is the 15% seller financing. Typically the note does not kick in until two years after the date of the sale. Then it can start getting paid back over a negotiated term.

For the record, just because the SBA is willing to do something does not make it right. In any instance.
 

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Jon L

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Something that's missing from this discussion is the purpose of the debt. Three different scenarios for your consideration:

1) Company buys and sells items for sale to the government:
  • Company receives order from the government
  • Places order with fortune 500 company
  • Pays for order with LOC or credit card
  • Ships order to government
  • Pays off loan when government pays bill
2) Successful chain of 5 restaurants takes out loan to pay for part of the opening of a 6th location in a similar city
3) Startup that's still a year out from launch decides it want to buy a bunch of server equipment instead of renting it from Amazon. Gets a $250,000 SBA loan to finance it...


The debt in #1 is about as secure as they come
#2 is a little riskier, but they've proven they can launch new restaurants, and they have the cashflow to support the loan even if it doesn't work out.
#3 is stuuupid.
 

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I can see your point.

It seems crazy to me that an that the bank is willing to do a highly leverage deal even though it is back by the SBA. Maybe I am completely missing something, but I've always known banks to be more shrewd investors. I guess it could be the fact that existing businesses with 3+ years of steady cash flow have proven concepts and are thus a safer bet.

As someone who in a past life (circa 2010-2012) audited banks I can tell you that some are anything BUT shrewd. One particular instance comes to mind when I was looking at a ton of underwater investments and asked a partner how to test it. She gave me a wry smile and said... "I don't know, I've never seen this happen before, good luck".

That was an interesting Saturday at the office. It might have been the first instance where I had this thought.......... If I'm going to solve problems that don't already have solutions, why not do it to benefit myself?

Thank you for reminding me of that moment!
 

Greg R

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As someone who in a past life (circa 2010-2012) audited banks I can tell you that some are anything BUT shrewd. One particular instance comes to mind when I was looking at a ton of underwater investments and asked a partner how to test it. She gave me a wry smile and said... "I don't know, I've never seen this happen before, good luck".

That was an interesting Saturday at the office. It might have been the first instance where I had this thought.......... If I'm going to solve problems that don't already have solutions, why not do it to benefit myself?

Thank you for reminding me of that moment!

That is pretty scary stuff! +REP

This thread has turned up some great answers and good conversation so far. The topic of debt is obviously too vast to cover here, but we have touched on a lot of good points.
 

CPisHere

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I started my first business, retail store, with an SBA Loan of $65k, and have used debt to grow it but am aggressive with paying it down. If I decide to open another store, or do any other major initiatives, I will use debt to do so. But I'd rather limit debt/put as much money as possible back into the business than grow faster or take on investors. That's the decision.

I used a small business Line of Credit (LOC) of $25k + $8k owner financing to buy my second (service) business. This business barely requires capital to grow, and the debt is not cumbersome, so I take my time paying it back.
 

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