Having worked with 1,000+ small business owners, I’ve found that most of them tend towards extremes when managing their capital structure: either they are too bullish and take on too much debt too soon, or they are too conservative and stifle their growth potential because they are paranoid about borrowing money.
Unsurprisingly, any pre-existing debt needs to be carefully assessed when deciding whether to finance a deal or not. So if you are planning to raise growth capital for your business, there are several things to bear in mind before approaching any investors.
For starters, not all debt is equal. In general, investors will be more concerned about senior debt (e.g. term loans and finance leases) than subordinated debt (e.g. unsecured borrowings), while shareholder loans are often more consistent with equity than debt (especially if they are unsecured and non-interest bearing). So unpacking your capital structure is an important first step.
Second, debt at a point in time is less insightful than the trend over an extended period, so don’t rely on a single set of annual financial statements or current management accounts. Are your liabilities growing or shrinking, and at what rate? An upwards trend isn’t inherently worrying, but that depends on the context. There’s a world of difference between borrowing money to grow and accumulating debt in a last ditch attempt to survive.
Third, it’s pointless trying to qualify debt in isolation. The debt ratio (i.e. ratio between total liabilities and total assets) is a common measure of solvency and collateralisation, but this is usually less critical to small business funders since they are far more sensitive to the cost and risk of seizing and auctioning off assets than banks and other large institutional lenders.
Instead, debt-to-equity, debt-to-EBITDA, and debt-to-cash (either free cash flow or net operating cash) tend to be far more relevant metrics when assessing the viability of funding a small business. The first of these clarifies the extent to which you have skin in the game, while the latter two validate your ability to settle what you owe.
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