Life lessons in business: Debt can be good but cash is king

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I have written before about the dangers of debt in business. The long and short of it is that I am not anti-debt. I just think you need to be very smart about it and you can’t let it ruin your life. Let me give you an example of good debt from a situation we are currently going through and I will share some pitfalls that could turn good debt in to bad debt in a heartbeat.

I believe in using debt for inventory, assuming it is a safe bet that you can sell the inventory. Let’s put it this way. Would I advise you to borrow $300K to buy a container of toys from China that you think you can sell but have no history with? No I would not. However, let’s take another scenario. Let’s say that you have been selling those toys for a few years and have a proven track record. You know that you sell $100K every month and an onetime opportunity comes up where you can buy $400K worth of those toys for $300K. Sadly, you don’t have $300K lying around.

That is a case where I would tell you to go borrow the money. Look at it this way. You are just pre-buying 3 months of inventory and you are getting it at a $100K discount. That is essentially dropping $100K into your pocket except for interest on the $300K. If you borrow the $300K at 10% and pay it off in 3 months, you are going to spend less than $5,000 in interest, leaving you with $95K in increased profit. That is a no-brainer. Yes, things might still go wrong but it is a risk worth taking.

Here is the takeaway: debt is your friend in situations where you have a proven business strategy and you are very comfortable that the debt will help that strategy either by increasing revenue, improving margins, or reducing expenses.

In our family business, we have a similar situation to the inventory scenario I just discussed. At times, it makes sense for us to buy a lot and as a result, we have times where the inventory in the basement is just at crazy levels. I have never borrowed money to maintain it but it does not take a rocket scientist to figure out that at our current growth rate, I am either going to run out of money to maintain it or am going to have to pass up some good buying opportunities because of lack of cash.

So I started looking for money. I somewhat naively typed “business loan” into Google and submitted a short application on LendingTree. Within seconds, my phone was going crazy.

What I learned very quickly in those calls was that the business of lending to business is a nasty one. Loan sharks exist for businesses just like they exist for consumers in the form of title pawn shops, etc. One thing I figured out quickly was that if it took someone a long time to explain how their loan worked, it was something I wanted nothing to do with. For example, someone called me yesterday, ready with “good news” because I am approved for a loan. Here is how the conversation went.

Him: 10 minutes trying to describe how the loan would work. (It sounded sort of like they took a payment out of bank account every day and I paid the loan off every few months and could then re-borrow the money again.)

Me: I really just want to know what the origination fees and interest rate are.

Him: More explaining their ridiculously complicated loan.

Me: Please tell me the fees and interest rate or I am moving on.

Him: We will charge you only 3% a month.

Me: Why would I be interested in a loan at 36% interest?

Him: It’s not. It’s 3% per month.

Me: 3% a month is 36% per year. Why would I be interested in that?

Him: You don’t understand. These are short term loans that you are not holding for a year.

Me: I can go anywhere and get this loan (note: that is maybe a slight exaggeration but not much). I can walk into Wells Fargo tomorrow and do it with almost no closing costs and an interest rate of 7%. Why would I consider an interest rate of 36%?

Him: Since you are only buying 2 months of inventory at a time, you will pay it off every 2 months. So it’s not 36% interest; it’s only 6% interest.

Me: Click…

I hung up on the guy because there are only two possibilities for him: he is either too dumb to do business with or he is a scam artist. Because you would have to be extraordinarily dumb to be in that field and not know that 3% interest per month equates to 36% per year (not including compounding), I decided that he was the latter and not worth one more second of my time.

Now, here is the question. If if that company is ripping people off, how do they stay in business? That answer is simple: they prey on the weak. They prey on businesses in a jam that have bad numbers and are desperate. I have often heard the complaint that lenders only want to lend to those that don’t need it in the first place. While that is not the case, the truth is that if you are financially weak, you will get taken to the cleaners by lenders. The good ones will pass you by and you will have to make bad deals with the sharks.

In other words, cash really is king. The best way to get good loans is to work hard to minimize your need for loans.

Guys, be very careful when you go looking for money. If you are established and have good financials, you probably don’t need to go to online lenders. Just start at your bank. Wells Fargo is the largest lender by far in the world of SBA loans. Even though there is a lot of angst about large banks out there and I personally like small banks, it is very likely that deals at Bank of America and Wells Fargo may beat anything else you can find. For example, I just learned this week that amazingly, Wells Fargo will do up to $150K as an SBA loan with no closing costs at all.

Loans should be simple. You need to know the term (length), the interest rate (annual, not monthly), and fees (closing fees, etc) and you need to know how to pay. As soon as you figure out that someone is trying to get you into a loan more complicated than that, run away. They are almost certainly trying to scam you.

Don’t be afraid of debt but be wary and smart. Above all, remember the sleep test. Only borrow money when it does not impact your ability to sleep.

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