By Ismail Abdur-Rahman, CEO iVIBES
In 1991, three guys from my neighborhood released a rap single that became an anthem of sorts across America: O.P.P.
From professional sporting events to neighborhood block parties, O.P.P. could be heard everywhere, and this hit changed the trajectory of Naughty by Nature's career, catapulting them to superstar status after their careers had floundered until that point. If O.P.P. worked for Naughty by Nature, it can work for any struggling entrepreneur, as well.
O.P.P. is a reference to other people's property, but for the purposes of this post, we'll assume that property means money. I'm sure that, by now, you are aware that 9 out of 10 startups fail. Why do they fail? The answer is usually that they run out of cash before they figure out how to make a consistent profit. Let's face it, cash flow is the key factor in the survival of a fledgling business. This is why several governments around the world are subsidizing lending programs for small businesses - if they don't have enough cash to deliver their products and services to the market, they'll fold like a deck of cards. This can have disastrous consequences, as small businesses are key drivers of economic growth, comprising 99% of employer firms in the United States and 49% of private sector employment.
Cash me outside
How about that? Well, let's just say that unless you are independently wealthy before starting your business, you may face some challenges handling all of your expenses in cash. Come to think of it, you might face challenges even if you have independent wealth. The last guy I worked for bragged a lot about how he never took a bank loan in his life and he still became a millionaire. It happened that he was the beneficiary of serendipitous circumstances that made it easy for him to do business in cash: he received a sizable inheritance from his father, and he was in the right place at the right time to broker a deal for the purchase of a fleet of trucks that netted him more than 150,000 British sterling in commission.
His early business success notwithstanding, he frequently ran into cash flow problems, and he usually ended up selling equity shares in his businesses to provide the liquidity he lacked. Cash flow problems and a struggling economy conspired to cause last year's revenue to decrease by $3.5 million last year. Currently, he's on the verge of bankruptcy because a former partner stole millions from him and left him on the hook for about $4 million debt to creditors, and because he's cash strapped as a result of that fiasco, he's selling the majority of his remaining shares to an investor at a horribly low valuation. There's a reason that having debt in the capital structure increases a company's valuation. Debt is cheaper than equity (as my boss now knows), and because of tax laws, debt increases the returns to equity owners.
Sure, not all debt is good debt. For example, student loan debt (unless you use it to get an MBA from Harvard or Stanford) and credit card debt can be the worst types of debt, and they have, in fact, been primarily responsible for scores of Americans declaring bankruptcy. Why? Well, one problem is that although student loans do provide a grace period, if you major in philosophy or something else that doesn't immediately lend itself to job preparedness in a busted economy, you won't be able to find a decent paying job fast enough to make the loan payments. Credit cards can have a similar impact if you spend recklessly (i.e., you don't purchase assets with them) and you anchor yourself to the minimum payment. The fact that credit card companies continue to extend your credit limit as long as you continue to spend and make the minimum payment doesn't mean that you're in a good situation; actually, this is just a setup to increase your indebtedness - it makes the credit card company money because they will eventually get all of their money, and it ruins your credit history and your life.
So, what kind of debt is useful for an entrepreneur? The Cliff's Notes answer is productive debt. What I mean is that if you can use debt to get a return greater than the cost of debt, then using debt might help push your business forward.
For example, let's say that you absorb a debt of $100,000 to develop/purchase products that you can sell for a 30% profit. If, at the end of the first year, you have a net profit of $200,000, you have managed to free your cash flow by taking the debt instead of paying cash out for the product development/purchase; your sales have amply covered the cost of the debt; and the valuation of your company, because of the debt-equity mix, has increased. Generally speaking, this is a win-win scenario.
Of course, you will need to do your due diligence in making financial projections for sales of products that you don't yet have on the market, but the general principle remains: if the cost of debt is less than the return you will generate by making capex investments, using debt is preferable to selling equity shares in your business. Don't make a short-term decision that has long-term consequences.
Also, you really have to review your business's strategic plan and financial model to see if it's realistic to plan growth by using cash flows. If you're in the FMCG industry and you're highly liquid and fairly mature, you might be able to fund growth with cash flows. However, this is highly risky, as not meeting cash flow projections could result in your inability to meet your obligations to supply chain creditors and maintain operating expenses.
Remember, cash flow is the life blood of small business. If you are targeting growth and you really want to take your small business to the next level, there's far less risk involved in using other people's money - it can free your cash flow, fund growth activities, and increase the valuation of your business.
Hey, if it O.P.P. worked for Naughty by Nature, you might want to give some consideration to using debt to fund your entrepreneurial growth. If you do it right, you could be singing Hip Hop Hooray in no time while watching your business take off.