What’s the right amount of debt?
There are several things to consider when deciding how much debt is right for your company. Debt affects ability to grow, operational risk and the amount of money available to the owners upon the sale of a business.
A bank (or other lending institution) will determine the high end of the borrowing range. How much a bank will lend will mainly depend on the business’ history, collateral and cash flow. Additionally, some companies might be able to obtain mezzanine or subordinated debt which will increase the total debt load. This type of debt is more expensive and, very often, includes some sort of equity compensation. The final alternative for outside capital is equity, which will dilute the existing ownership.
Cash is vital for growing companies. Generally speaking, cash flow generated from operations isn’t enough to cover the requirements of a fast growing company. Bank debt is the least expensive and most available source of funds and for many companies it will be enough to cover the costs associated with growth.
Bank debt alone might not be enough for some companies, either due to an extreme rate of growth or pre-existing debt. This is when the question of capital structure becomes more complicated. Banks are risk averse and generally won’t lend more than a business can comfortably afford. Increasing debt can provide increasing returns for a growing company up to a point. At this point, the risk of defaulting on the debt outweighs the positive effects of leverage.
As long as the company can continue to make required debt and other payments and stay in compliance with its debt covenants, debt remains a very effective tool for growth. But if the company is not generating enough cash flow to cover expenses or is just getting by, it has likely reached a point where a recapitalization would be in order. Businesses have failed because owners did not want to dilute their interest and became overleveraged as a result. Owning a lesser percentage of a company makes good sense if it the alternative is owning nothing.
Unfortunately, there is no perfect formula for determining the perfect capital structure. It will depend on the company’s profit margins, growth rate, and projected future business. A good place to start is by determining how much a bank will lend. If that doesn’t cover the costs associated with growth, some detailed financial modeling and risk assessment will be in order.
There is another consideration regarding debt levels upon the sale of a company. The amount a company sells for is referred to as Total Enterprise Value. Generally speaking, the business owner(s) will be responsible for paying off any existing debt out of this amount. This is the point when the right capital structure ultimately pays off. The outside capital (debt or equity) allowed the company grow and reach a valuation that made a sale worthwhile. The capital structure at that point will determine how much the owner nets as a result of the sale.