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Interest: Another Mouth To Feed

The first question coming to many people's minds when they want to start a small business is, "Where can I borrow the money to start my business?"

First, most new small businesses aren't ideal candidates for loans. Traditional banks won't loan money to small start-up companies. The banks are not rewarded for the risk they take by charging a little extra interest.

Remember, loans must be repaid. If the small company doesn't succeed, where will you get the money to repay the loan? In addition, without significant upswing potential of an equity investment, most knowledgeable investors do not like to absorb extra risk. They will be happy to keep their money in treasuries or highly-rated, established, large company bonds.

Banks will loan money to larger start-up companies. They will also charge slightly more interest for the money. Similarly, if the larger start-up company is able to float its own paper as debt financing, it will need to pay a relatively high rate of interest. These are the so-called "junk" bonds.

Some investors like to invest in a well-diversified portfolio of junk bonds (usually, via a junk bond mutual fund with low expenses) for the extra return or to buy junk bonds in default which might pay more than is commonly believed. But, the latter is for knowledgeable speculators only.

Even larger start-up companies fail. For example, Excelsior-Henderson, the wannabe top-end motorcycle maker of Minnesota recently entered Chapter 11 bankruptcy. For years, everyone touted Excelsior-Henderson as a great growth company and admired the quality of its bikes. Only problem. Nobody bought any. Unable to earn money or generate cash, government loans to the company were defaulted upon among other obligations.

Now, the government has a vested interest in promoting business. Often state governments will battle each other to lure desirable start-ups to their state. So, in a roundabout way, a government loan is semi-equity in scope. The hope is that the company will grow and provide job growth. Plus, it's the taxpayer's money being invested. It's always a bit easier to make a risky investment with other people's money.

Similarly, companies underwriting the bonds of larger, speculative companies profit handsomely. It is not an investment in such companies, but the process of getting others to invest in them, that serves as their reward.

The lesson to bankers who pay attention is, "Don't loan money to small start-up companies." If even the larger start-ups, which have an excellent chance of making a go of it, can fail, what are the chances for smaller start-ups, where management is less tested, turning out to be a good loan investment where there is no upside to compensate for possible failure?

But, just because a loan is a bad deal for the bank, doesn't mean it's a good deal for you, as the small business borrower. It could be a bad deal for you too. Remember, these loans are a bad deal for banks because often they can't be repaid. But, we are assuming you intend to repay your loan and be successful. You will repay not only the loan, but also a relatively high rate of interest.

In Jane Bryant Quinn's book, Making The Most Of Your Money, a great personal finance book, Bryant Quinn says having interest to pay is like having "another mouth to feed." Debt is just like a child. It takes money to support. The interest you pay is a regular, ongoing expense.

The same is true in small business. When you borrow money, you must pay interest regularly. Usually a good chunk of interest. Interest becomes a fixed-period cost, just like any other overhead cost.

Smart small business owners usually try to minimize overhead when they begin a new business. They want to put their money into things that more directly generate a profit--things like marketing and product. Of course, borrowing money is one way to have money to invest in these things.

But, unlike starting a business with your own money, once a loan is taken, tick-tock starts the interest clock. If the new business doesn't generate repayment of the loan quickly, you have just taken on another fixed expense.

Having fixed expenses means you must generate revenue sufficient to cover these fixed expenses. Fail to do that, and the fixed expenses will deplete your capital and drive you out of business.

The same is true with interest expense. At the very least, you need to be generating a return on your invested assets at least as high as the interest rate you are paying on the loan. The achievable rate of return on invested money in a start-up is often very uncertain, and that is a problem with start-up companies borrowing.

Next time you contemplate a small business start-up loan, ask yourself if a loan is really the best avenue.



Financing Your Small Business from our online guide to starting a small business.