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EXIT STRATEGIES

Giving Credit to Debt

You may think of debt as a drag on your business. But that's not necessarily how the experts see it.
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Valuation

To leverage, or not to leverage: that is the question for many entrepreneurs -- at least the ones who have the option of borrowing funds to finance their company's growth.

In today's environment of rising interest rates, debt has started to look less appealing than it looked throughout much of the 1990s. But for some business owners, it always was undesirable, no matter what the cost of borrowing was. "I'm doing $2 million in sales with only a $20,000 credit line outstanding," says Jerry Edwards, co-owner and president of Chef's Expressions, a catering company in Timonium, Md. "With the exception of a single two-year period when we borrowed $50,000 to pay for some expensive equipment tied to an expansion effort, we've always funded our growth out of cash flow. I had a credit line that I didn't dip into for 10 years!"

Edwards is scarcely alone in his aversion to borrowing. "We see many mature, privately held companies that are debt free by choice, as well as many service companies that are debt free by necessity because they don't have the assets to support a long-term borrowing arrangement," reports Z. Christopher Mercer, the CEO of Mercer Capital Management Inc., based in Memphis.

Although many company owners consider their lack of indebtedness a strong selling point, does having no debt on the books really enhance a company's value when its owner is seeking an outright sale or a public or private stock offering? "The quick answer is no," says Jeffrey D. Jones, president of Certified Appraisers Inc., in Houston. "From a marketing standpoint, a buyer is purchasing gross value, which is a function of its earnings and what the marketplace will pay for them."

At times, Jones acknowledges, debt can affect a business's appraised value. "If I were hired to assess a company's value for a divorce settlement," he explains, "the key number to determine would be its net equity, which is calculated by subtracting liabilities from gross value. The more debt, the lower the net equity." But that number would not have an impact on the company's sale price in the open market.

Business owners who are proud of keeping their companies free of debt may wonder whether they'll get at least an intangible benefit: some kind of recognition for their ability to resist financial temptation and run a tight ship. However, an investment banker, a professional investor, or a potential buyer will evaluate the situation differently from the owner. "Professionals are not going to be making those kinds of judgments or worrying about whether you deserve personal credit or not," says John J. Egan III, a partner at law firm McDermott, Will & Emery in Boston. "Instead, their focus will be on where the company is today, which is what's going to determine whether it will be sellable and, if so, for how much."

Jones agrees. "Some owners may have been able to avoid borrowing because they inherited a large amount of money that they could put into the business, or they left their last jobs with a big early-retirement package. Those are the kinds of things that are completely irrelevant to the value and marketability of a company. So why should anyone care about them?"

Meanwhile, some experts argue that choosing a debt-free approach to entrepreneurship actually may have a negative influence on a company's value at sale time. Says Conor Reilly, a partner in the New York City law firm Gibson, Dunn & Crutcher LLP, "Sophisticated buyers and investors will look for an overall capital structure that is intelligently constructed. Having some debt is a good thing if it allows your company to increase its revenues and return on equity. If you don't have any debt, and an outsider suspects that its absence has hindered growth, that's a detriment."

That's not to say, however, that it makes sense to load up on debt just to convey the right impression to the outside world. Depending on the dynamics of your industry, as well as the type of growth that you are pursuing, borrowing may be unnecessary, costly, and constricting. "I can completely understand why some entrepreneurs don't want to get involved with it," says Egan. "In many cases, they'll have to sign a personal guarantee for the loan and accept all kinds of covenants, which may even restrict growth if they need to obtain waivers all the time from their bankers."

From Edwards's vantage point, there just never seemed to be any compelling reason to take on more than a minimal level of debt. "I don't believe it's possible to maintain the kind of high-quality catering operation that I've got while pushing growth any faster than 15% each year," he says. "And that's what we've always been able to do without any help from a loan. Anyone looking at my company can see that it can sustain steady growth without my running to the bank three or four times each year for more cash." He adds, "I'd only think about selling it for a great offer. But if I did, I wouldn't want to use a big chunk of the proceeds to pay off debt."

An internally funded growth model might impress a potential buyer who shared the seller's objectives and assumptions about the industry. But for people with much faster growth on their minds, warns Reilly, "someone who boasts about running a debt-free business will seem out of touch, maybe even antiquated. The business world has evolved in such a different direction from that. I can't recall, for example, the last time I saw a company with a $100-million capitalization that didn't at least have some credit-line facility. How could you support that kind of growth without it?"

Ultimately, debt offers an advantage that may indirectly improve a company's prospects for a lucrative sale. As Egan points out, "Potential buyers do reference checks. If they can talk to a banker who has a good history of working with the company and its owner, that's only going to help. It even helps if the banker tells the prospective buyer that the company has had some tough times along the way but has always managed to live up to the terms of the loan and has always provided reliable financial information." For owners who can't yet qualify for a bank loan (or who really don't want one), that type of validation can also come from nonbank lenders, suppliers, or strategic partners who may provide financing while the company grows.

Jill Andresky Fraser is Inc. 's finance editor.


The Right Debt Mix

The question of whether debt increases or decreases a company's value has no one-size-fits-all answer, but here are some guidelines as you think about your own company.

Do you anticipate doing an initial public offering or selling your company within the next three to five years?
If so, then you've little choice but to ratchet up the company's growth rapidly -- which means that a credit line probably is essential. If your company is too new or too small to qualify for a credit line on its own, look for ways to pair an equity financing deal with a bank loan. (That strategy is increasingly possible, especially for companies who land investments from established venture capitalists, private-equity funds, or repeat angel investors with contacts in the banking community.)

Is debt justifiable?
If your company's lack of funds stems from cash-flow problems that require corrective measures (perhaps in your accounts-receivable or -payable systems), don't expect an outsider to applaud your unnecessary borrowing.

Are you running a fast-growing service company or a company with few assets that can serve as collateral?
Then you're in a bind. You probably could use some debt, but unless your personal financial position is very strong, it's unlikely that you'll be able to persuade a banker to give you a loan. Instead of relying entirely on equity deals to bring capital into the business, pursue other sources of financing, with the goal of moving to a traditional credit line as soon as you establish a track record and a cash-flow stream. (Consider starting with a credit line from your credit-card company or with a contract-financing deal from a nonbank lender.)

Can you control your company's hunger for capital?
That should be a major concern for any growth-oriented company. Although some debt is good, too much can be catastrophic. "If you owe too much, or if it's coming due sometime soon and a prospective buyer would have reason to worry, then debt can be a big strike against your company," says John J. Egan III, a partner at law firm McDermott, Will & Emery in Boston. So walk the line between abstinence and self-destruction -- ideally by layering both debt and equity arrangements into your growing company's capital structure.


Please e-mail your comments to editors@inc.com.

Related resources:
Defining Key Financial Ratios
Financial Ratios Worksheet

Last updated: Nov 1, 2000




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