When to borrow to grow your business
I am often asked about when or if a company should take on debt to help grow their business.
Here are my thoughts:
Sources of Capital
There are three source of capital to grow your business:
Revenue – well, actually, profit (revenue less expenses).
Equity – selling shares in your company
Debt – borrowing money that will have to be repaid
Cost of Capital
Profit, or cash flow from operations, is the best source of financing there is. It’s repeatable and free.
But often it is not enough. Also, for tech companies, it is often years in the future.
Equity is the most expensive form of financing. You are giving up a piece of your business.
Venture capital looks to generate at least a 35% return per year. That is expensive!
From a pure cost perspective, debt is almost always cheaper than equity. You don’t give up any ownership in your company (unless the lender asks for warrants. These are like stock options).
The downside with debt is that you have to pay it back.
When it comes time to sell your business, lenders get paid before shareholders.
So, there is risk to borrowing to grow your business.
This means that you need to know when is the right time to take that risk.
Most VC-backed companies are burning money. So the money needed to repay the debt must come from money raised by selling shares.
Your business can’t actually afford to repay the loan until it is profitable.
When is the right time to add debt then?
In simple terms it is when your business is de-risked. Unpacking this:
You are post-product market fit
You have proven, repeatable channels to find customers
You know your unit economics. You know how much a customer is worth. You know how much to pay for a customer
The goto market aspect of your business is a proven formula.
When you have achieved this milestone, debt is a great way to keep repeating that formula.
This helps you grow faster than you would without the debt.
This means you are using a lower cost source of funding for a low-risk use. This is the way to do it. Keep equity for higher risk items like developing new products.
I hope this simple framework helps you think about when to borrow to grow your business.
Photo by Andre Taissin on Unsplash