Take a minute and imagine that you just purchased a new business in February 2020. When you did it, you choose to finance the business with a five-year note instead of a 10-year note. You didn't like the idea of having debt, so you wanted to get it over with as soon as possible and pay the least amount of interest. You decided to stomach the bigger monthly payments, even though it would make cash flow tight.
Then the unexpected happened. Covid-19 hit and your business was forced to close for several months. Once you were allowed to reopen, capacity was limited and personal protective equipment needed to be added to your list of monthly expenses. For the foreseeable future, you are going to be worrying if you can pay all your bills at the end of the month. Now, you are wishing you had chosen to finance the business over 10 years instead of five.
While I use the example of a business acquisition, this information is important for all businesses that have, or are considering, taking on debt. Always make sure you understand the terms and conditions before signing on the dotted line. Debt is an amazing tool for business owners who are looking to grow their business, as long as they utilize it correctly. Give yourself a comfortable monthly margin in case of emergencies. Remember, in times of uncertainty, cash is king.
Financing strategy is always about playing offense and defense. That's why I often encourage entrepreneurs to think about using the SBA -- to buy themselves the flexibility of 10-year money -- especially when there is no pre-payment penalty. Any SBA loan under 15 years has no pre-payment penalty. This means that if times are great and money is flowing, you could pay off the SBA loan in five years. Or, if a crisis hits and cash flow is tight, your monthly payment is still lower since it's based off a longer term.
The next question I always get is: "What about the interest rate?" To this I always answer: "Don't be so interest rate sensitive!" Now, this doesn't mean you shouldn't be on the lookout for those outrageously high interest rates you see with some online short-term lenders -- those are never a good idea. But, when it comes down to 4 percent on a five-year bank loan and 6 percent on a 10-year SBA loan, don't automatically assume the loan with the lower interest rate will be better for you. Having the lower monthly payments will come in handy, not if, but when, your business faces challenges in the future.
I spoke with an entrepreneur yesterday who had received an Economic Injury Disaster Loan (EIDL) loan two months ago and was now considering paying the loan back. She felt that her business had mostly recovered, and she didn't like the idea of having the responsibility of paying back a loan. My advice for her? Not so fast.
In a period of uncertainty, possession is 99 percent of the law. Her EIDL loan is due over 30 years, at a nominal interest rate. The monthly payments have no severe impact on her cash flow. In my opinion, she could consider the payments like an insurance premium, and hold on to the cash. That does not mean she should use the money frivolously, but there is little reason to not hold onto it.
Remember that financing strategy is a combination of offense and defense. You want to be situated to take advantage of unexpected opportunities and deal with surprises you weren't anticipating. This philosophy is more real than ever in these uncertain times and plays a huge role in thinking long, not short.