When I was a kid one of our family activities was going camping, and I quickly determined my favorite part of camping.
Playing with fire.
I loved every aspect of the fire. Starting the fire, stoking the fire, burning things in the fire. You get it… I was that kid at the campsite.
It was all fun and games until one day I left the fire unsupervised and caught the campsite on fire.
Debt management for entrepreneurs is the same as a campfire. You start off respecting the fire until you grow too comfortable and get burned.
Managing debt is an invaluable part of financial planning for business owners.
It is a tool that can be used to accelerate growth, but it can also be a burden that eventually burns your business to the ground.
In this blog, we are going to look at all of the areas you need to be aware of when it comes to debt management for business owners.
Debt Management for Entrepreneurs
Debt is a tool to incorporate into your business and personal finances. If you understand how to use it properly it will provide the leverage you need. Used improperly it will get you stuck in a rut that can feel impossible to dig out of.
We are going to break our thoughts into two distinct categories.
Personal Debt:
Credit Cards
Mortgages
Business Debt:
Lines of Credit
Bank Debt
Let's dive in.
Personal Debt
I am a believer that all debt is not bad. There are others out there that would tell you all debt on the balance sheet is bad. The Dave Ramsey followers. The reality is if all people listened to this advice families collectively would be in a better spot financially.
Why?
Because most people take on too much debt and do not have earning ability to pay off that debt. We are writing this blog with the understanding that you have excess income and a decision to make on how to allocate those funds. One of those decision points is what to do with debt on your personal balance sheet.
Let’s start with the most straightforward debt discussion.
Credit Cards:
Credit cards are an amazing tool when used properly. The first step to using credit cards is to rename them. I prefer to use the term deferred payment cards over credit cards.
This is exactly how this tool should be used. Every month you defer your payment until the end of the month. At the end of the month, you pay off the credit card in full.
Under no circumstance should you leave a balance on your credit card. There are two primary reasons why.
Interest Rates – Typically these cards will have interest rates over 20%. Paying this much in interest is NOT a good financial decision.
Credit Score – Every day you don’t pay off your credit card you hurt your credit score. Your credit score is what allows you to get better terms on debt you may need such as a mortgage or car loan.
Credit cards are a fantastic tool to earn rewards and points. They must be used responsibly. They cannot be used to fund the life you want to live. Abusing credit cards in this way will only get you in trouble.
Mortgages:
Your first big debt was likely the mortgage you took out on your home. I know this was the case for me and my family. Mortgages are our first look into the grey area. Before we talk about how to make this decision let's take a look at the different types of mortgages available.
Fixed Rates:
Fixed-rate mortgages are the most common home loan. Typically these come in 15 and 30-year terms. This means the bank will give you a loan that you have the right to pay off over the course of the term. The bank will amortize the loan over the course of 30 years.
Variable Rates:
Adjustable rate mortgages (ARMs) come in all different terms. These are common for business owners or families with income that varies. Banks love consistency they don’t love variability. The rates on these mortgages will fluctuate at the end of your ARM term. For example, if you have a 7-year ARM your rate will move up or down after the 7 year period.
How do we decide what to do with our mortgage?
We look at these three factors.
Interest Rates
Liquidity Needs
Peace of Mind
Interest Rates:
If you have a mortgage that was locked in a few years ago you probably have a 3% mortgage. We are going to be less likely to want to pay this off now that rates have gone up. The other consideration with your interest rates is how long you have been paying on your loan. If you have a 30-year loan the amount of interest you are paying in year one is dramatically different in year 30.
Consider this chart when we look at the amortization effect on payments being made at the beginning of the term vs the end of the term.
Each payment made is $5,995.51 per month for 360 months, but depending on the date the amount of interest is significantly different.
Payment 1 - $5995.51
Principal - $995.51
Interest - $5,000
Payment 360 - $5,995.51
Principal - $5,965.68
Interest - $29.83
This concept must be taken into account when considering paying off a mortgage.
Liquidity Needs:
When it comes to business owners the one thing you can’t run out of is cash. We are always monitoring this when we look at paying off big pieces of debt like a home. The last thing we want to do is pay off our mortgage only to realize we need the money out of our house. This is part of the goal-setting process when we look at financial planning for business owners.
Peace of Mind:
This part of the decision is the nuance. We have clients who are simply not comfortable having debt. There is nothing wrong with that. This often comes from personal experiences in their life. The right decision isn’t always the one the spreadsheet tells you to make. Peace of mind is a factor that should be considered when you are looking at debt.
So remember there is both good debt and bad debt on your personal balance sheet. The key to making the best decision is combining what the spreadsheet tells you with the heart. This nuance will look different for each family. There is no one-size-fits-all.
Business Debt
Debt inside of your business and debt on your personal balance sheet shouldn’t be treated the same. Before you tell me I am wrong here me out. Debt on your personal balance sheet will never make you money. Debt on your business balance sheet CAN make you money.
The key to business debt is understanding that even though it can make you money it doesn’t always make you money. I have seen both sides. I have seen debt turn a small business into an empire, but I have also seen businesses go up in flames because of leverage (remember to respect the fire).
This framework can help you ensure your business doesn’t go up in flames.
Line of Credit:
The line of credit (LOC) is your friend in business. Typically they cost nothing to set up and give you quick easy access to capital. The mistake most business owners make is they don’t set up a line of credit until they need it. This comment is all too familiar.
“Why would I need a line of credit we are cash flow positive every month.”
If this is how you would respond to my question it means it is time to evaluate your LOC. The good news is that banks love giving out lines of credit when things are going well.
You will hear me say this time and time again. The one thing you cannot run out of in business is cash. A LOC is your last line of defense.
As you read this and think... this sounds great what's the catch? Here it is.
With fast and easy comes better bank terms. With any negotiation, if you choose easy it typically means you aren’t getting the “best” terms. This is the case for a LOC when it comes to interest rates. Typically a LOC is going to have a floating interest rate that will increase or decrease as the fed moves rates.
Business owners need to be aware of this. With the recent changes in interest rates, we have seen business owners burned by this. They have taken out a LOC and analyzed the payments they need to make to get it paid off. In their head, they believe the LOC will increase profits and have the debt paid off in no time. What they didn’t keep in mind was the increase in debt service with the Fed raising rates. This is the situation that can get many owners upside down on debt.
To recap a LOC is your friend and you should have one. If you don’t this should be an action item after reading this blog.
Bank Debt:
Traditional bank debt can be a wonderful tool for a business owner. Unlike a LOC bank debt can provide you with a stable structure and a known cost. Let’s look at the uses of bank debt along with factors you should consider.
Uses:
There are two primary uses for bank debt.
Internal Growth
External Growth
Internal Growth:
Businesses that grow typically need cash to grow. I saw a recent example of a business owner who completed a large real estate build-out to set up their business for the next stage of growth. It would have taken years to build up enough cash to do this without debt.
This is a great example of a responsible use of debt for internal growth. There was a clear vision that required capital to get there.
A key understanding when using bank debt for internal growth is being a great storyteller. Banks don’t hand out millions of dollars hoping you will pay them back. They had out million-dollar checks to the businesses they believe will pay them back.
If you are a business owner looking to grow understand that part of your role is to tell a great story to your bank. This will allow you to get better terms on the debt that you take.
External Growth:
Many of the best businesses in the world have used outside capital to grow externally through acquisitions. This has been the flavor of the week for the last few years with acquisitions becoming more mainstream.
When you are looking at completing an acquisition the first step is understanding how you will fund the acquisition. In a normal transaction, traditional banks will lend up to 2X EBITDA for senior debt. Senior debt is a fancy banking term that simply means the bank has priority to get paid first. Giving this right to the bank will allow you to pay them a lower interest rate than junior debt. It is typical for a transaction to have multiple levels of debt. As you go further down the debt stack you will typically have to pay a higher interest rate. These are economic factors to consider when looking at an acquisition.
This is why you often see companies bring in “investors”. Investors will provide you capital for equity in the business which will reduce the economic stress the debt service may put on the business.
Bank debt is a great place to look for building your businesses in the long term. It is the most tested way to get large amounts of debt for running and growing your businesses. Understanding the game the bank is playing will allow you to get the best terms for your businesses.
When evaluating your business debt or personal debt let this be your one takeaway. There are a million ways to skin the cat when it comes to debt. The key to managing your debt is being disciplined and having a plan. The key to getting burned is taking on too much debt with no plan to pay it back.
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Our goal at Moment Private Wealth is to help you reach your ideal outcome. At Moment Private Wealth we specialize in helping business owners have a plan for their debt.
If you are an entrepreneur who is concerned about debt, schedule a call to talk with a Moment founder.
Not sure what questions to ask, check out this video on 10 questions you should ask when interviewing a financial advisor.
Get in Touch With An Advisor
Frequently Asked Questions
Here are some answers to questions I received frequently about this topic.
Are you a fiduciary? Moment Private Wealth serves clients as a fiduciary 100% of the time.
How does Moment Private Wealth make money? We are only paid in one transparent way, by our clients. We receive no kickbacks or participate in any profit-sharing arrangements. Our fees are simple, transparent, and clear for our clients.
How are you different than other financial advisors? We are specialists in working with professional athletes and business owners. We limit the number of new clients we take on. This allows us to provide unparalleled value and highly personalized service to professional athletes and business owners. We work as a team to service our clients. We believe in building a team of “A” players. This ensures our clients receive world-class tax, estate, insurance, and investment strategies. We focus on educating first, then executing.
Where do you hold my investments and how can I see them? Moment Private Wealth uses Fidelity Investments as a third-party custodian for our client investment accounts. As a third-party custodian, Fidelity safeguards and provides reporting to you and the IRS each year. Clients can also access all financial information via the Moment Private Wealth Client Portal.
How do you work with other members of my team? We believe in the power of the team. For most of our clients, their team consists of Moment Private Wealth, an accountant, an attorney, a banker, and an insurance specialist. We help our clients build out their team of individuals or work with existing partners clients have. Our goal is to ensure every family has a team of experts to protect their interests.
How much debt should I have in my business? Debt in your business is a tool that should be leveraged carefully. Without a proper debt management plan you could find yourself in trouble. Your plan should include how you are going to pay off your debt.;
What does your average client look like? Our clients are nearly all athletes and business owners. Our average client has a net worth greater than $5M. The strategies, solutions, and planning that we implement have a high-net-worth and ultra-high-net-worth client in mind.
How do I pay less in taxes? Taxes are going to be your largest lifetime expense. Our goal is to help you pay the least amount possible and never leave the IRS a tip. Our team of specialists understands this and works to reduce your taxes today and in the future.
Should I pay off my mortgage? Paying off your mortgage is an art, not a science. The key to this answer is understanding the science behind your mortgage and the art of knowing what is important to you.
Why should I consider hiring Moment Private Wealth? Great question! But first, let us explain why you shouldn’t hire us. If you’re looking for an advisor who will pitch shiny object investments or be a “yes man” you are in the wrong place. Why? Because we believe in being truth tellers and only giving advice that we take ourselves. The investments, strategies, and planning we do are all things our advisors do with their own money. If you are an athlete or business owner interested in things like lowering your tax bill, investing smarter, and finding a trusted partner we might be a good fit.
*Moment Private Wealth offers information on tax and estate planning that is general in nature. Tax and Legal advice are not provided by Moment Private Wealth. Consult an attorney or tax professional regarding your specific legal or tax situation.
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