You’ve heard repeatedly how ‘it takes money to make money.’ One of the main reasons you probably want to make money is because you don’t have any money now. Should you borrow to invest in your business? Here are some things to consider as you weigh your options.
Start up loans
There are capital-intensive businesses that require loans in order to begin operations, but unless your startup is an airline or a wind farm, the odds are decent that your business isn’t one of these. Avoiding debt in your formative stage frees you from having to repay your creditors on their timetable but it has the less obvious benefit of forcing you to pay close attention to your business model.
This was one of the great lessons of the late 90s internet bubble, where businesses raised millions only to later find their businesses weren’t viable. Forcing your business to live within its means sharpens your awareness of where your break-even point is and what you must do to turn a profit.
Exceptions to the rule
Are there situations where debt makes sense for startups? Of course there are, but be careful. An example of debt successfully used for a startup was a company called Jibbitz. The founders, a husband and wife, founded Jibbitz on their kitchen table in 2005. Jibbitz designed, manufactured and distributed plastic charms that children used to decorate the ventilation holes in the Crocs plastic clogs that were popular at the time.
In order to fund Jibbitz, the couple borrowed $150,000. Eighteen months after founding Jibbitz, they sold the company for $20 million. While this seems to contradict the advice about startups avoiding debt, consider three things. The founders understood that Jibbitz was a fashion product that needed to piggyback on the popularity of Crocs themselves, and they didn’t have the luxury of growing organically in order to take advantage of a time-sensitive opportunity.
Second, the money was raised only after Jibbitz had signed orders for its products, and needed to pay its Chinese factories in order to fill the orders. There was never any question about customer demand, expected profit margins, or Jibbitz’s ability to repay the loan.
Third, when Jibbitz was sold long after the loan had been repaid with interest, the lenders got to share a part of the $20 million payday that otherwise would have gone entirely to the couple. Debt was necessary to grow this business, and the couple only took on debt when they knew what it was for and how it would be repaid, but their lenders made a profit many times the face value of the loan, which had long since been paid back.
If you are reading this after the fact and your business has already taken on debt you may be facing another decision – should I retire the debt or invest to grow the business and then retire the debt when my business is making more money than it is at present. Here you should consider the advice of finance guru Dave Ramsey, who recommends avoiding debt if at all possible.
Ramsey’s advice is unambiguous, telling his readers that “You don’t need to borrow money to make it big. Instead, save for what you need and then expand. It lowers risk and minimizes mistakes.” This is sound advice. Eliminating debt and building up cash reserves insulates you from business downturns, and gives you greater flexibility to make decisions without first having to make sure your lenders are on board.
Search the internet and you’ll find examples of famous business people who had debts so great they declared bankruptcy before having later success. Your search will repeatedly uncover Henry Ford, Walt Disney, H. J. Heinz, Milton Hershey, and Abraham Lincoln.
If bouncing back from bankruptcy is a common occurrence, ask yourself why the same names, most of whom went bankrupt in the 19th and early 20th centuries, keep showing up as examples. In 2011, there were 50,000 business bankruptcies. Even if Hershey, Disney, Heinz, Lincoln and Ford had all gone bankrupt last year and bounced back, they still would account for only 1/10,000 of all business filings. Avoid debt if possible.
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