I’m frequently asked how to fund growth. I’m going to answer that question here, too, but first I want to lay a foundation for why I answer that question a certain way. In the end you may disagree with me, which is fine, but you at least deserve more than just a simple answer.
Let’s first review our options for funding sources.
First, growth can be funded from ongoing operations. When more comes in than goes out, there’s a certain amount of leftover funds called profit, and that profit can be used to make investments in the future of a company. These investments may take the form of hiring an employee before you really need him or her, purchasing equipment for that employee, building out a nice new space, etc. The money to do these things isn’t missed because there’s plenty of money there in the form of ongoing profit.
Second, growth can be funded by deferring expenses. Even though you may be on the hook for certain obligations, you may decide to not pay them promptly, stretching the vendor out and using the money in other ways until new money comes in. So a client might prepay you for media expenses, but in this scenario you don’t set it aside for that media expense but instead use the funds to cover growth.
Third, growth can be funded with outside funds. These can come in the form of a line of credit, a loan, or the simple use of credit cards. You are borrowing money, and in the process borrowing from the future. That’s because the money eventually needs to be paid back, and you’re betting on the fact that in the future you’ll not only have enough money coming in to cover expenses, but you’ll have enough extra coming in to cover the cost of paying back the funds. One important point to keep in mind: the proceeds of a loan are not taxable—but the amount of principal that you pay back isn’t deductible, either.
Fourth, growth can be funded with operating or capital leases. An operating lease is essentially a locked in rental agreement. A capital lease is a locked in purchase agreement. These are expensive propositions and very inflexible.
Fifth, growth can be funded with a personal loan to the company. Say you have more liquidity in your personal assets than your corporate ones, and you decide to loan money to the corporation. This is really a self-dealing loan between parties at arm’s length, but it can be a useful tool to cover temporary shortfalls.
Sixth, growth can be funded by cheating or stealing. You wouldn’t think that I’d need to put this on the list, but you’d be surprised at how many principals do this. For example, they withhold deferred retirement funding from an employee’s paycheck, at their request, but then don’t remit the funds to the retirement plan. Or taxes are withheld from a paycheck but not remitted to the proper taxing authority.
Why This Matters
So those are the possible sources of funds, but why does this matter? Most importantly, it matters because there is a strong correlation between your choice of funding sources and the (eventual) possible failure of your business.
Debt is like a pain pill. It numbs the underlying condition and you can get hooked on it.
Think of it like this. You need something, or at least you think you do. But you don’t have the cash for it. On the other hand, you feel so strongly that you need it that you’re willing to try one of the other funding sources listed above just to get it. Doing so allows you to ignore the real problem, and that’s this: if you need it so badly, why isn’t the business profitable enough to be throwing off enough cash so that you can pay for it up front? There’s an underlying condition there that really should be addressed, but your use of debt enables you to ignore that condition and just let it continue.
Some of the firms not making much money use debt inappropriately. Stated otherwise, not using debt doesn’t ensure a profitable operation. On the other hand, wildly profitable firms never seem to borrow from the future.
“Of course,” you say. “Because they are wildly profitable they have enough cash to fund operations!” It’s a chicken and egg thing, though. Why are they profitable? Because they don’t ignore operational issues but rather deal with them directly and promptly. There’s nothing (like debt) to mask the problems they face. At a more practical level, they have no payments going out, so they have more money! Using debt is a vicious cycle.
There’s a fair bit of overlap in how you use money in the business and how you use money personally. The “personal” in “personal finance” is just that. So it’s a little hard to talk about this without getting personal in the process. There is some overlap.
I’m not beating you up, though. Learning the value of money and avoiding debt didn’t sink into my own way of life until I made my own mistakes with money, and that’s when I learned the tough lessons. I have also had some good mentors who have demonstrated financial values and been terrific guides.
I’ve also learned by watching my clients make many, many mistakes with fixed obligations instead of facing the music and paying cash for things.
All this to say that I hope you’ll take these recommendations in the proper spirit, knowing they are coming from someone who made mistakes, has seen mistakes, and cares about the outcome.
In a nutshell, I would only incur fixed obligations (loans, credit lines, balances on credit cards, and capital leases) for appreciating assets. And even for them I’d be hesitant to incur fixed obligations.
How realistic is this? Very. I follow this myself, and probably one-half of my clients follow it. It’s difficult to make that initial transition to an obligation-free business life, but with determination it’s quite possible. Afterward, you’ll be surprised at how much money you have and discover that it’s easy to pay for things as you need/want them.
I’m a huge risk taker, but I’m very conservative with funding growth and operations. Being conservative that way actually enhances your ability to take risks. That’s because even in the worst case scenario you just drop down to zero. You don’t drop below zero (via fixed obligations) and thus there’s nothing in the past that must be cleaned up in the present or the future.
So the basic philosophy is this: avoid fixed obligations entirely, but maybe consider them for appreciating assets. Assets in that category include real estate, some art, etc. But the typical exception you’d carve out is buying your own building. That is addressed elsewhere in this manual, but generally it makes sense to buy a building if you can pay 30 percent down and then pay off the note within fifteen years.
Some Final Reasons to Avoid Fixed Obligations
In addition to masking other issues that should be addressed in other ways, there are a few other good reasons to consider running your firm without fixed obligations.
First, you spend less. There was a study by Consumer’s Union that found that paying cash for things like a dinner resulted in lower spending. There was something about paying cash that made people look more carefully at their expenditures. Try it yourself some time. Pay for a nice dinner out of cash instead of with a credit card and see if it doesn’t feel a little different.
Second, avoiding fixed obligations makes it much easier to cut spending during a downturn. Having fixed obligations usually means that you have to cut deeper on the personnel side of things, which is unfortunate.
Third, funding growth with cash forces you to grow at a more manageable pace. Spending only cash acts as a natural brake to runaway growth because there’s only so much cash you can safely spend without jeopardizing your business.
“So many aspiring entrepreneurs I talk with believe that at the heart of self employment must be passion for your work, a journey towards self fulfillment, an end to repetitive, unchallenging tasks assigned in the corporate world. While all of those things are reasonable goals to have, the true heart of self employment is making a profit. Becoming self employed isn’t limited to filling the hours of your day in a constructive fashion, you have to make a profit or your attempt at starting a business is just an unpaid vacation.” —Morris Rosenthal, Becoming Self-Employed Without Losing Money, 2010Download Full Article (855 KB pdf file)