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Financial structure, debt, and why they matter

Two recent articles in The New York Times deserve every entrepreneur’s close attention, the first dealing with small businesses caught up in the fireworks when their lenders go under and the second dealing with the impending bankruptcy of General Growth Properties, the second-largest owner of shopping malls in the country and the first major commercial real estate bankruptcy in this downturn.

The flagship book in the Shoestring Venture series, The Startup Bible has a long section on capitalizing a startup along with a common-sense discussion of financial structure. Since most entrepreneurs skipped finance class, the details and arcana of funding and capitalizing a business are often ice-cold on the backest of back burners. Yet it is vitally important — even for the thinnest of bootstrap operations — to be clear that debt is always part of the capital structure of a business. It is never the same as consumer debt which is largely about finding ways to buy things you can’t pay for right now. Debt to finance a business is always about raising the return on the money you (or other equity investors) put into the business and it is just as important a part of your business strategy as a product idea or marketing scheme.

Because of this strategic nature of debt, if you get it wrong, you go bust.

We say it best in our book:

Most small business entrepreneurs think of debt as a necessary evil, that onerous keep-you-awake-all-night horror you need when you can’t pay bills. In terms of financial structure, however, debt is just another investment in your business and a lender just another investor. Equity investors, including yourself, own the business and can participate in profits and the gain in the business’s value—the return is potentially unlimited. Lenders (debt investors) help to fund your business in exchange for part of your revenues in the form of interest on the loan . Their return is limited to the interest, but unlike equity investors, they have first claim on the company’s assets (or your assets, if the business is a sole proprietorship or general partnership). It is more often than not desirable to have a portion of the business’s financial structure represented by debt. For most corporations, 30% to 40% of the financial structure is debt. Why? A debt investor only gets their interest; any profits and capital gains above that go to the equity investors, thus increasing their return. From the very beginning, you need to consider debt as part of your financial structure and how it increases, or decreases, the equity return.

Before you borrow one dollar, the starting point is to consider any long-term debt as an investment in your company — even if the lender has no idea the money is going into your business. (Short-term debt, that is, credit you’ll be retiring in a few short weeks, we can, incorrectly for now, consider the same as consumer debt). In a business’s financial structure — even the shoestringiest of shoestring ventures — the purpose of debt is to amplify the returns on equity, the “ownership” part of a business’s capital structure. This leveraging effect on equity is often reason number one for assuming debt — even in cases where startups need to borrow money in order to open their doors in the first place.

However, debt contains certain risks. Payments on debt are often the senior obligations of a company. So, even when no money is coming in, the loan still has to be paid. Loan holders also have first dibs on the assets of a company (or a person) and they have the right to “call” a loan — that is, demand full payment — if parts of the agreement are not upheld (such as making your payments).

Strategically, debt amplifies the returns on the money you, and others, invest in the business as owners of the business. At the same time, debt amplifies the losses you suffer if the business eats up more cash than it makes. That, of course, is the Janus-faced nature of leverage: great when the going is good, hugely awful when the going is bad.

Your goal, then, in using debt to help finance your business is to maximize the upside while minimizing the downside.

It is, of course, entirely possible to take on debt that amplifies the good times but doubly amplifies the bad.

Take the case of General Growth Properties, whose debt has wiped out the company. It is the second largest mall builder/owner in the United States — chances are, you shopped at one of their malls this week (we’re particularly fond of their Valencia Westfield Mall).

Like many companies, General Growth took on normal, everyday business debt in the form of corporate bonds. The nice thing about bonds is that they force a discipline on the company. They often require a debt-to-equity ratio as well as numerous other covenants. Now, any kind of debt can sink a company (GM and Chrysler are on the skids because of their bondholders) provided a big enough downturn in business. But because of the discipline they impose, bonds amplify but they don’t wildly amplify bad times.

General Growth isn’t going bankrupt because of the bonds it holds. It’s going bankrupt because a significant amount of the debt it holds comes in the form of mortgages on the property it owns. Mortgages, unlike bonds, don’t impose the same level of business discipline. Because mortgages are secured by the underlying real property, they don’t come with many of the common-sense business restrictions that bonds entail, such as capital requirements.

General Growth got as big as it did by relying heavily on mortgaging the underlying property of companies it acquired — as well as mortgaging properties it already owned (in much the same way homeowners took out home equity loans to buy gas grills, trips to Disneyworld, and SUVs). So General Growth buried itself under mountain of debt — which, like all those home equity loans, was perfectly cool as long as the value of the underlying property continually increased.

But the value didn’t continually increase. It fell, and General Growth Properties is underwater on many of the malls it owns, that is, the mortgages it holds on many of its malls is higher than the market value of the property. That’s what I mean about “double amplification.” General Growth is in financial trouble (rents are decreasing as retailers go out of business) and servicing debt amplifies that trouble. But they’re also getting it from being underwater on their mortgages; by relying so heavily on mortgages in their capital structure, General Growth set itself up to have the effects of the recession doubly amplified on their balance sheet.

Any entrepreneur who financed a startup with a home equity mortgage is facing the same problem. The underlying soundness of their business is threatened now from two sides: nonperformance of their business as well as the nature of the debt itself.

The second strategic issue to deal with is the negotiability of the debt. Debt-holders act like every other investor in the solar system: they want to maximize their returns and minimize their losses. If the business runs into trouble, that doesn’t mean debt-holders will push the foreclosure trigger and bankrupt the business. They may agree to restructure the loan in terms of principle, interest, or payment period if that will either minimize their losses or maximize their return.

This is the problem faced by the Shoulders in the first New York Times article. They hold $10 million in debt that they securitized with the value of their fitness gym. Their lender went bankrupt and they discontinued payment on the loan (not smart); they were, however, having problems meeting the terms of the loan anyway. They offered the FDIC, the new owner of the loan, 70 cents on the dollar, but the FDIC balked. The loan was purchased by a vulture investment company for 34 cents on the dollar and the new owner of the loan called the entire loan in for nonperformance.

Here’s the problem: the underlying value of the real estate securitizing the loan is worth far, far more than the loan itself. Think of this from the lender’s point of view. The Shoulders offer 50 cents on the dollar for a loan you paid 34 cents on the dollar for (about a 50% return). However, if you foreclose on them and sell the property, you can recover 100 cents on the dollar (almost tripling your investment) without losing money in the foreclosure process. Which would you choose?

So the Shoulders are stuck with a difficult loan to negotiate. The loan amount was too great to service with their monthly revenue (even in good times), but the value of the underlying property virtually guarantees full recovery of the face value of the loan in a foreclosure. Restructuring a loan only works when it’s in the best interests of the debt-holder.

So the Shoulders will probably lose their business, pay off the full face value of the loan, and also pay off all costs associated with the business’ financial distress (foreclosures usually end up distributing the cost of financial distress across both the lender and the debt-holder).

Finally, the Shoulders show us that all long-term loans need to be structured against best-case and worst-case revenue projections, which is one reason to take your prospective financials deadly seriously. Most start-ups I work with have prospective financials that are simply wet dreams and no more. Not only do the financials have to be realistic, I’m a big fan of doing “worst-case” financials. For instance, when we bought our big old house here in L.A., we qualified for a mortgage nearly three and a half times greater than the one we eventually took. Unlike the mortgage company (and this was before the mortgage companies started throwing money at people), we calculated our ability to pay a mortgage based on one or both of us losing our jobs. When that happened (it happens, folks), we didn’t lose our house. We’ve got foreclosures on every side of us up and down this valley, but we’re still securely ensconced on God’s brown little acre here.

Business debt works the same way. The Shoulders needed to calculate their ability to service their debt based on prospective financials that reflected both growth and a downturn in the business. That would mean getting a smaller loan and delaying some of the improvements they made to the gym, but it would increase their negotiating ability in a downturn. Remember: a debt-holder not only wants to minimize risk, they want to maximize returns. It does them no good to foreclose on a loan or call a loan and give up all that interest.

We’ve been running a fairly popular series here on business strategy. Let these two stories be a warning that financial structure is as much a part of your startup’s, or small business’, strategy as anything else. It’s never catch as catch can — it is long-term and crucial part of your business strategy.

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2 Responses to “Financial structure, debt, and why they matter”


  1. Milken: Why Capital Structure Matters…

    In a Wall Street Journal opinion article published last month, former high-yield corporate bond salesman and trader, Michael Milken, who has his share of detractors, penned an opinion titled Why C……

  2. […] (The mall is owned by General Properties, on the verge of bankruptcy, which I discuss here.) […]

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