Free At Last
There's a quandary many of us face once our companies move beyond the start-up phase and begin to grow rapidly. To finance the growth, we get a loan from a bank, which will lend us the money only if we agree to put up our personal assets as collateral. The more capital we need, the bigger the loan we get, and the larger the personal guarantee becomes. It's our debt to the bank, and it hangs over us like the sword of Damocles. No matter how much money we make, no matter how high our net worth is outside the business, we remain at risk of losing everything, even our homes, should the company fail.
To be sure, the banks don't really want our homes and probably won't take them away from us in the event of bankruptcy. Lenders insist on guarantees mainly to make sure people stick around if companies tank before paying off their loans. Even in bankruptcy, after all, your business may still have valuable assets--uncollected receivables, for example--and you know better than anyone what they are. Without the guarantee, however, you have no incentive to stay and help, since you won't be getting any of the money. It will all go to your creditors. The personal guarantee gives you a powerful reason to remain on the job. As long as you do your part, the bank will usually be willing to work out a reasonable settlement with you.
But that doesn't make the guarantee weigh any less heavily on you. Every entrepreneur I know who has a bank loan yearns to get out from under his or her personal guarantee. Most people believe there are only two ways to do it: sell the business or pay off the debt. I used to dream about paying mine off as well. Like other members of my generation, I had been raised to believe that debt was bad: If you had any, you should get rid of it as soon as possible. I thought, "Once I pay off these loans, no one will have a claim on my business; I'll be able to keep all the money I'm now spending on interest, and I'll be free of my guarantees." Fortunately, I didn't follow through on that. If I had, I would have hurt the business. In a growing company, debt is your friend. You need it to capitalize on the opportunities available to you. If I had focused on paying off my loans, rather than building the business, I might have escaped my guarantees, but my company would be much smaller and less profitable than it is today, and it would be worth a fraction of its current value.
It turns out, however, that there is a third way to get rid of your personal guarantees, and I took advantage of it last year when we replaced our bank loans with a loan from a nonbanking financial company. In our case, the nonbank was an investment firm we'd been doing business with for more than 20 years. We'd partnered with it on several fairly large deals, including the acquisition of a huge chunk of land adjacent to mine (see "The Art of the Deal"). In the process, we'd built great relationships with the firm's leaders and staff. They understood our business, and they knew who we were, how we operated, and what values we lived by. They also knew we'd always delivered on our commitments, even when doing so created hardship for us, and they respected us for it. There was trust all around. So when we decided it was time to refinance our debt, they were the people we turned to.
Now, I should note that we had great relationships and an impeccable track record with our banks as well, but I've never known one that would let business borrowers out of their personal guarantees. If you ask why not, the banker says, "It's just not our policy. We can't do it." While I could understand why banks have such policies, I really didn't want to go on living with the discomfort you feel when most of your wealth is tied up in one business and someone else has a claim on any assets you own outside the business. I knew that I'd feel better without the personal guarantees, and better still if I could diversify my portfolio by taking some of my equity out of the company and investing it elsewhere.
My partner Sam and I came up with a plan to do both. We approached our friends at the investment firm and told them that we had relatively little debt for a company our size and were thinking about borrowing some more money. They said they could lend us up to five and a half times EBITDA (earnings before interest, taxes, depreciation, and amortization). We didn't want anywhere near that amount. Instead, we suggested another approach. We pointed out that we were spending $3 million a year in interest and principal on our bank loans, which were structured more or less like a home mortgage. That is, we had level payments over the terms of the loans, but in the beginning most of the money went to pay interest, whereas in the end most of it would go to pay down principal. Because we'd taken out some of our loans many years earlier, our interest payments were less than half the total annual bill. That was important because you pay interest with pretax dollars and principal with after-tax dollars. "How much could you lend us," we asked, "if we continued to pay $3 million a year but with all of it going for interest rather than principal?"
The investment company's people said we'd have to pay at least a small amount of principal every year, but they could structure the loan so that most of each payment would go to interest. In that case, they could lend us almost twice as much money as we currently had in bank loans. We'd be getting a seven-year loan with a partial amortization of the principal. Instead of paying $1.5 million in principal each year, we'd be paying about $750,000, and our annual interest payments would rise accordingly. At the end of the seven years, we'd liquidate whatever we still owed on the principal in one large balloon payment.
Consider what we'd get. First, our annual interest payments would rise from about $1.5 million to about $2.25 million, and the extra $750,000 could be deducted from our pretax profit. Let's say we pay about 50 percent of pretax profit in taxes. While the $1.5 million reduced our taxes by $750,000, the $2.25 million would reduce them by $1.125 million--a swing of $375,000 a year that we could reinvest in the business.
Second, the investment company's loan would allow us to pay off our debts to the bank and then some. We could take the additional money out of the company and use it to diversify our personal investments outside the business. Granted, I wouldn't do that if I were 25 or 30 years younger. I'd reinvest the money in the company. But, for me, security is as important as growth. The company has all the cash it needs to keep growing at its present rate. My priority these days is to get some of my eggs out of the basket they've been sitting in for most of my adult life.
Last, but far from least, I would be liberated from my personal guarantees. The assets I owned outside the business would be mine indeed, with no strings attached. It helped, of course, that I had such a long history with the investment firm. Its people knew me and my businesses well enough that they didn't need guarantees. But it takes time to build such relationships. If you want to get rid of your guarantees someday, you should start developing one with a nonbank--a private equity firm, for example--now.
Let me hasten to add that I'm not recommending reckless borrowing. Sam and I have been very conservative, maybe too conservative, in managing our debt. In this case, the investment company was willing to lend us a lot more money than we took.
I should also mention that this had an impact on the negotiations for the sale of my businesses (see "The Offer," parts one through nine). By the time the potential buyer came along, we were already working on the refinancing deal with the investment firm. This put us in an interesting spot: If we dropped the refinancing and proceeded with the sale, we would save about $200,000 in closing costs. But if we went ahead with the refinancing and then did the sale, it would cost us about $500,000 in prepayment penalties to the investment firm--and a couple million more because Sam and I were planning to offer the investment firm a chance to buy a small amount of equity. We decided to go ahead with the refinancing anyway--in part because I wasn't at all confident that the sale would happen.
As a result, I was in a much stronger position when the negotiations with the potential buyer began. With no personal guarantees and a sizable portfolio of investments outside the business, my attitude was much different from the one I would have had a few months earlier. I didn't feel any financial pressure. Sure, I wanted to realize the full value of the business, but the financial considerations weren't going to determine the outcome of the negotiations. I tried to make Chris Debbas, who was putting the deal together, understand that. I said, "Whether I do this deal or not, I have enough money." When I realized he didn't believe me, I showed him a recent brokerage statement. "Right," I said. "Now you understand that it's not about money. Just remember that." Chris may have heard me, but he obviously wasn't able to get the message through to the most important board member, the one with the veto, who apparently believed right up to the end that I was bluffing, that I needed the money and would return to the table.
From that perspective, the greatest benefit I got out of refinancing our debt with a nonbank was freedom--specifically the freedom to do the right thing without fear of the financial consequences for me and my family. That kind of freedom is the most valuable reward a business can bestow upon you.
Norm Brodsky (email@example.com) is a veteran entrepreneur whose six businesses include a three-time Inc. 500 company. His co-author is editor-at-large Bo Burlingham.
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