Debt is a necessary part of any business journey. By taking loans or seeking financing, you're giving your company the fuel it needs to grow. The key, however, is understanding business debt, healthy loan practices, and the difference between financing that can result in explosive growth and the kind that cripples your business. Jeb Ory, co-founder and CEO of social advocacy platform Phone2Action, said financing is a crucial ingredient in the growth of many companies.
"Access to capital," he said, "can be the difference between explosive growth, linear growth and the death of your business."
At the heart of good and bad debt are your own aims as a small business owner. While it may sound obvious, it's important to only take on debt to accomplish goals, spur your company forward or provide the necessary fuel to build your business. It can be easy to take on business debt to accomplish one thing and not have a plan for the rest of the money, for example.
"Debt should be used to extend runway and help businesses make purchases that they couldn't normally make if it makes them more competitive," said Ory. "The type and amount of debt should be directly linked to the type of business."
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Healthy business debt isn't a defined amount
The amount of debt that's "healthy" for your business to take on varies widely depending on your own situation. Instead of reaching for a defined number, view healthy debt as debt tied to specific growth plans and strategies for your business.
Harj Taggar is the co-founder and CEO of Triplebyte, a hiring platform geared specifically toward software engineers and startups. He said having a defined plan is one of the most important aspects of handling debt.
"Good debt is tied to something solid with a clear plan for why it's helpful," he said. "Bad debt is money you spend without understanding how it impacts your business."
Taggar and Triplebyte explored some loan options but ended up raising funds through an equity round. This kind of financing supports Taggar's point – it was exactly what his business needed, and he had a realistic plan for how to build his business with the capital.
Ory also weighed his options but ended up getting funding through venture debt, which is provided by a specialized bank that serves small SaaS (software as a service) companies.
"Technology has flattened barriers to entry, and it's easier than ever for new companies to enter a market," he said. "The ability to expand your business ahead of cash flow is critical to growth and can provide a competitive edge itself." [Interested in getting a loan for your small business? Check out our breakdown of the best small business lenders in 2019.]
Creating a plan to deal with business debt
Creating the right plan for your business may involve speaking with a financial professional or hiring a chief financial officer. Depending on your cash flow, it's important to find the ideal expert. If you're not a financial expert but are looking to take on business debt to grow your business, these professionals can help you move in the right direction.
"Review [your] financials holistically with a financial professional at the end of each month," Taggar said. He also said it's important to do more than just investigate the numbers – by diving into fundamental business metrics, you can assess your business's condition and lay out a realistic financing plan.
Ory said Phone2Action has a CFO and accounting department that helps break down the company's financial situation and ensures they're moving in the right direction. If you don't have the funds or ability to work with a professional, do your best to realistically assess your situation. If you make a solid plan for the capital and properly assess your growth, you can successfully raise funds. Taggar warned companies to be wary of situations where projected growth doesn't align with the small business debt.
"If you took on a level of debt based on growth assumptions that proved to be optimistic," Taggar said, "[but] growth slows and you're slow to react, you can be left in a fatal situation."
Types of business funding
There is a wide range of funding options for small businesses looking to grow. While some companies opt to fund their operation through bootstrapping, many others will take bank loans, raise funds through angel investors or connect with local venture capitalists for funding options. If you're looking for funding options, check out our guide to choosing a small business loan. Generally, small businesses find funding from the following sources:
- Friends and family
- Personal savings
- Local angel investors
- Federal and state grants
- Alternative online lenders
- Other creditors
How personal liability factors into business debt
If you run a small business, you should set up a separate legal entity so you are personally protected from problems related to your business. This means establishing an LLC, corporation, sole proprietorship or partnership. If you've established this type of business, it doesn't mean you're off the hook when it comes to financial liability.
If, for example, you take out a loan with an alternative online lender, you'll likely be required to sign a personal guarantee. The personal guarantee ensures the lender that if your business defaults on payments, you will be personally liable for any outstanding balance. This is something to be very aware of when signing nontraditional financing agreements, like merchant cash advances.
Even if you reach a loan agreement with a bank or more traditional lender, make sure you read the fine print to understand where personal liability comes in. Depending on your agreement, you may have to put up personal collateral to acquire the loan as well.
Long story short: Even if you've established a separate legal entity for your business, you can still be personally liable for financial fallout.
What happens if you default on a business loan?
The default process is where tough realities come to fruition for all parties involved. Business.com has a full breakdown on the exact process on a few general types of loans – unsecured, SBA and secured, for example – for in-depth reference. From a high-level view, it's important to know going into any loan agreement exactly where you're financially exposed personally and professionally.
It's also important to remember that default procedures are subject to state law and vary accordingly. When a default occurs, banks or creditors follow a few systematic steps toward acquiring collateral and cutting the overall loss of the loan:
- The default process will likely take several months, if not a full year.
- Creditors will usually try to work with you to avoid default. In the event of default, your balance will be accelerated, which means you're now on the hook for the full loan amount. This includes any predefined fees, like collection or attorneys' fees, established by your lender
- There are three likely outcomes in the event of a default: The lender will set up a payment plan for you, the lender will seize and liquidate your business and personal assets, or the lender will cut its losses and settle with you for an amount less than what you owe.
- If you're about to default on a loan, it's important to work with a lawyer to ensure you reach the best outcome.
Business debt: How much is too much?
Unfortunately, there's no simple answer to this question. The amount of debt your business can handle directly depends on your business's financial position. Establishing good cash flow can allow you to take on more debt to grow your business.
As Taggar suggests, focus on tying small business debt to growth plans – you should be taking loans to accomplish something, not just to fund regular operations. If you're worried about how to understand how much debt your business should take on, it's important to work with a financial planner.
Bottom line on business debt
If you've taken on small business debt that you can no longer pay, it's important to act fast and stop spending money. This is logical and standard protocol. Both Ory and Taggar said by tightening up and getting financially sound, you can better your position and become less reliant on debt.
"Start cutting costs immediately," Taggar said. "It's a painful process, but the longer you delay it, the worse a position you'll be in."