Thursday, May 1, 2008

Should Your Company Have Debt

A lot of business owners have a hard time differentiating between their personal and company finances, yet they need to be regarded as completely and wholly separate. Many business owners who subscribe to a debt-free philosophy for their family (except for a home mortgage) want to impose the same philosophy on their business. Experience shows that not only is this not prudent, but it actually will cost them money in the long-term. Allow me to explain:

Every company has a cost of capital, or in other words, a cost associated with the money it either borrows or receives as equity contributions. The cost of debt is typically much lower than the cost of equity, but this is what confuses business owners - they do not associate a cost with the equity they either have or are going to invest or retain in their company. We know that traditional debt is costing most businesses 8-9% per year right now (not including the tax benefits associated with debt), but how much does equity cost?

Using a basic analysis, let's assume that a large, well-established, multi-national corporation returns 10% per year to its shareholders (in the form of dividends and growth in stock price). This 10% return represents the firm's cost of equity, or the return with which the shareholders are satisfactorily compensated for their risk. Your company's cost of equity is most likely higher because your business represents much more risk. Perhaps you are not very geographically diverse, or perhaps you have one customer that accounts for more than 50% of your business. Maybe your industry is traditionally volatile and/or cyclical, or maybe your product or service is not yet proven. And don't forget that emerging and medium-sized businesses are viewed as more risky than larger companies.

There are many ways to quantify this risk, and it is called a risk premium. In other words, how much more than the 10% would someone expect to earn from investing in your firm. Assuming your risk premium is 6%, then your cost of equity is 16% (average market return of 10% plus your risk premium of 6% equals 16%).

So, how does this apply to you? Let's use an example that assumes your cost of debt is 8% and your cost of equity is 16%. First of all, since interest is tax deductible and equity is not, we need to reduce your cost of debt to truly understand your overall cost of capital. Assuming you are in a 35% tax bracket (federal and state marginal brackets combined), your cost of debt drops to just 5.2% (one minus 35% equals 65%, then multiply 65% by 8% to arrive at 5.2%).

Now, let's assume you need $100,000 to grow your business to the next level. You could draw against your company's line of credit at 8% or sell enough of your company to raise the $100,000 required. The debt will cost you $5,200 in interest the first year, but your investor will be looking for a return of at least $16,000 in the first year (sometimes they are willing to wait longer than a year to realize their return, but they eventually will want at least a 16% annualized return). Obviously, the debt solution is the most prudent for the current shareholders.

Even if you want to put the capital into the business yourself, your ownership won't change (if you already own 100% of the company). So, you would be risking $100,000 for no additional stake in the business and its future profits. Sure, you would benefit from the growth your $100,000 facilitated, but you could still benefit by using the bank's money. In essence, you give away $5,200 per year to the bank until you can pay back the line of credit in return for keeping all of the profits and value generated from the capital. No matter how you slice it, you would be much better served to use the bank's money than your own capital. The best case scenario is you generate a return far in excess of 16%. The worst case scenario is $5,200 per year, not your entire $100,000.

You should, for all intents and purposes, diversify yourself personally with your $100,000. Most of your net worth and your salary probably come from your business. It is your role as a shareholder to diversify yourself. And, although this may seem counter-intuitive, investors and outside professionals do not normally favor or assess any additional value to a firm that operates debt-free. According to an article in the USA TODAY on April 17, 2008, the 164 companies (including Microsoft and Google) in the S&P 1500 that are currently debt-free have experienced worse returns during this credit crisis than those with debt ("Lack of Debt Doesn't Boost Firms' Stock"). A Financial model can help you keep to the goals you have with your business.

The proper structure and utilization of debt is one of the most beneficial financial strategies a business can have and execute. In fact, research and experience have shown over and over that the right use of debt in your business will increase the value of your business.