A few years ago, I was part of a panel discussion fielding questions about small business lending from business owners whose businesses were all around the country. One of the questions asked to the group was, “How much should I borrow and when?”
One of my colleagues on the panel said, “You should borrow as much as you can every time you can because you can never know when you’ll have the opportunity to borrow in the future.”
I couldn’t disagree more—and said so.
How much should you borrow and when?
Popular media today would have every business owner believing that money is the answer to every small business challenge they face. I call it the Myth of the Shark Tank.
It’s true that a lack of capitalization is one of the primary reasons many small businesses fail to thrive and grow—or fail altogether, but borrowing at the wrong time or borrowing too much can burden a small business with a lot of financial stress it doesn’t need and can actually handicap growth.
I also recognize that my approach to business financing might be considered pretty conservative by some, but is influenced by the years I spent working in my father’s small business and the time I spent at the helm of my own. My dad believed there were really only two times borrowing was the best decision.
- To improve the ROI of a project
- To add value to the business
Let me give you an example. As a teenager, I worked in the warehouse of my dad’s industrial supply company. We sold bolts, nuts, flat washers, and other hardware that we shipped in and out of our business in kegs that could weigh up to a couple of hundred pounds each. In the first few years of the business we didn’t have a forklift, which would have made loading and unloading pallets of heavy kegs of bolts off trucks a lot easier.
My dad recognized that it was creative problem solving, more than money, that would help his business grow, and a forklift was an expensive piece of equipment he felt would be really nice to have, but didn’t fit in the above two categories. While he was saving to purchase a used forklift, he arranged for our deliveries to come in on a lift-gate truck. That way, we wouldn’t need a forklift.
I vividly remember the day when we finally bought the forklift. And to this day, I remember that lesson I learned from my dad and try to separate business needs from business nice-to-haves.
What is Your Loan Purpose?
The first question every business owner should ask before they borrow is, “What is my loan purpose?”
In other words, why are you borrowing? Is it to purchase a quick-turnaround inventory? To add an outdoor eating space to your restaurant? Build a new warehouse? Launch a new marketing campaign?
This is an important first question because it will not only help you answer questions about loan terms or loan type, it will also help you determine the loan amount you should be seeking.
Whenever I talk to small business owners about their financing needs and have the opportunity to ask, the first question I always ask is about the loan’s purpose. My next question is usually, “How much money are you looking for?”
Unfortunately, all too often, the reply is, “How much can I get?”
They are neck-deep into the Myth of the Shark Tank and are convinced that all they need to meet their business challenge is additional capital. Let me go on record now, just in case there are any doubts, that is the wrong answer and can lead a business down a slippery slope to financial trouble. I’ve seen this happen more times than I like to count.
Borrow enough to meet your loan purpose and no more. And, borrow at a term that is appropriate to your loan purpose.
For example, if you own a restaurant and are borrowing to buy a commercial pizza oven, like the TurboChef Fire countertop, for $5,598, you probably shouldn’t be thinking of a $20,000 small business loan. I think it’s fair to add 10% or 15% to the anticipated actual cost of your loan purpose to cover expenses like shipping, installation, or some other unanticipated related expense, but borrowing substantially more than you really need can become expensive very quickly.
There is a cost to borrowed-money—regardless of the lender you choose. Those costs can add up quickly if you’re not careful.
Avoid the Temptation to “Stack”
Stacking can mean a lot of different things, so let me define this term within the context of this discussion. Most reputable lenders will file a notice with the Secretary of State where you do business that you now have a loan with them. It’s called a UCC filing or Uniform Commercial Code filing. It’s how your lender let’s other creditors know that you have a financial obligation to them.
Unscrupulous lenders regularly review these publicly available filings to look for potential customers. Once a loan is filed, it’s not uncommon for a business owner to get a phone call that goes something like this, “Hi business owner, I noticed that you recently got a loan of X amount from ABC Lender, could you use another $5,000 or another $10,000.”
Because these individuals likely know the lender you are working with, they are willing to “stack” an additional loan on top of the loan you currently have based upon the underwriting of the first loan. They don’t assume your current loan into a refinanced loan, but simply add another. I’ve seen loans stacked two, three, even more times until the business can’t even begin to service all the debt and ultimately defaults on everything.
Because their fees and interest charges are typically very high, they are willing to run the risk that you will only be able to make periodic payments for a few months before the house of cards starts to tumble. These predatory lenders put your business and your lender at risk because they didn’t anticipate the cash flow burden that the additional monthly payment obligation would add to your ability to make your loan payment to them.
Stacking vs. refinancing
Stacking and refinancing are not the same thing, though. You need to know the difference.
If a lender refinances an existing loan, they assume the old loan and fold it into the new one. Stacking is simply adding one or more additional loans on top of the first. The former puts the lender and the borrower at risk because the additional loan(s) weren’t part of the original underwriting and risk evaluation. The former is a new loan based upon the underwriting and risk evaluation of the new lender.
My advice? Avoid Stacking.
How much financing do you really need?
I’m convinced that there are more financing options available today than ever before. In other words, the bank isn’t the only place to find a loan. With that said, it’s really important to know why you’re borrowing, how much you really need to borrow, and how much you can afford to pay for the privilege. The answers to all of those questions start with, “Why am I borrowing.”
Ty has been writing about small business and the business finance topics that impact a business’ bottom line for almost 20 years. With over 35 years in the trenches as a Main Street business evangelist, author, and marketing veteran, he makes the maze of small business finance accessible by weaving personal experiences and other anecdotes into a regular discussion of some of the biggest challenges facing small business owners today.