It is sad how our minds have been conditioned a certain way towards debt. We are told that debt is bad, but there is good debt that can work for an entrepreneur.
There are cases for and against debt. It was the Holy Grail that allowed the automobile, housing, banking and furniture sectors to become successful; it was also the curse that ushered the world into the economic meltdown in 2008.
So, what is good debt and how has it benefited those who know how to play the game?
In real estate, people use debt in innovative ways, like going to the bank to apply for finance for a new house. Once the bank approves, a tenant is brought in and their monthly rental is used to repay the loan. Then they go back to the bank as they still qualify for another property as their income at the time of application still remains the same. This qualifies them for another property, and the model is replicated while tenants service the loan, and their balance sheet increases.
Property developers use this model with a cluster of residential buildings, apartment blocks, and major developments. Developers identify the land, get the correct approvals and compliant paperwork in order, then they hire architects to draw the building plans. Once this is done, the properties are sold off-plan and this money is used to construct the infrastructure.
Another sector where people use debt, with less risk, to become successful is franchising. Firstly, franchises have a proven business model with high probability to succeed. Secondly, banks are more willing to finance new sites or buy an existing branch if the franchise has an established brand. With good management, the debt will be settled.
As entrepreneurs in Africa, we need to be savvy in gearing debt to work for us, and understand the power of leverage.
The recession hit when the US economy was over leveraged in real estate asset class. This is the same asset that many entrepreneurs use as their capital base. They approach banks to take another bond on their house to start a business, or grow it, at the risk of losing their primary residence should things not go according to plan.
Leverage is crucial when you are dealing with financial institutions, particularly banks. However, there is another avenue where leverage is not necessarily a physical asset; there are venture capitalists that fund a company on the perceived current or future value of the company. Others go further by focusing on the team behind the company, credibility and successful track records.
Above all, entrepreneurs need to be careful not to over-leverage themselves. When under-leveraged, the risk is manageable.
Start-up entrepreneurs are famous for bootstrapping their companies, until they produce a viable prototype or penetrate the market. An example of this is Fuseware, a successful African tech company founded by Mike Wronski before he sold it to Ornico.
This presents a challenge between two funding models: debt versus equity financing. Well-structured debt is preferable, provided the company can service the debt in the short term. This is best option for expansion purposes.
Equity is best for start-ups and growth-stage businesses. In this regard, an investor buys a stake in the company and takes on the same risk as you. The downside is that that the entrepreneur loses some control the moment an investor comes into a company.
Sooner or later, it is going to be necessary to approach capital markets to raise money. The fundamental reason for listing on a stock exchange is to raise money. Today, there are other reasons, but raising capital is the main one. A company’s share price is based on perceived value that might be influenced by its income, assets or track record. At the end of the day, the company is worth what the market is prepared to pay for and what investors agree to sell shares for.
There are many times when an entrepreneur’s personal debt overlaps with his company’s debt, predominantly in small to medium sized companies. If able, entrepreneurs should only deal in debt held by the company, rather than their personal accounts.
While debt is not entirely encouraged, any company that is going to be of global significance needs to be familiar with it.