The Negative Aspects of Leverage

I recall sitting in a second-year enterprise faculty class called Acquisitions of Closely Held Businesses. The guest speaker was an expert in leveraged buyouts (LBOs). He stood on the whiteboard and scribbled something along the lines of:

BUY COMPANY AT 2.5x FCF.

20% EQUITY, 80% DEBT

SERVICE DEBT IN 4 YEARS

SELL COMPANY FOR 2.5x FCF

ROI = ?

The response was a 400% return on investment. In any scenario, you’re allowing the financial institution to put up 80% of the money, and once the financial institution is removed from the equation, it’s all yours. Gravy. It’s just money. This speaker has completed it many times. Purchase company. Leverage to the utmost. Pay off your debt. Firmly promote it. Rinse, lather, and repeat. Ah, the allure of mathematics. It makes all of the elements seem to be quite simple.

I recalled that guy and his @#!&$ calculation on the whiteboard as I went to the bank to withdraw cash from our joint financial savings account to cover payroll and the cost on our tapped out line of credit score. I used to be waking up in the middle of the night, wondering what we’d have to do to keep going and whether we’d be able to service the debt with our receivables (note: don’t borrow money from yourself until you have the receivables to pay it back).

When everything goes according to plan, leverage maybe your friend, since other people’s money (OPM) allows you to achieve far greater financial goals. When you utilise OPM, you should purchase items that you would not have been able to otherwise. When you use OPM to buy an appreciating item, the leverage is to your advantage.

On the other hand, nobody at business school wants to discuss the other side of the coin. They don’t talk about how leverage may go wrong. Let me enumerate a few of the drawbacks of leverage.

You sign the mortgage.

No bank will accept a wet behind the ears entrepreneur at his word and lend him a large sum of money based merely on his EIN or DUNS for trustworthiness. No. You’ll personally guarantee that mortgage, and if you don’t pay it back, they’ll foreclose on your whole home. I’m hoping you’re ready for it.

You may be careless when you have leverage. You’re careless with your money since you have extra money that you didn’t earn in any other way.

Few people have the self-discipline to simplify the organisation to pay off the debt. Instead, they do as we did, pay the bare minimum, and only pay when there is more and nothing “more” to spend the money on. For years, our credit score lingered unnecessarily. We treated it like a pet that we didn’t have to get rid of.

You won’t be able to reinvest or offer more to your employees if your free money circulation is depleted. We were repaying debt rather than investing in incremental advertising to create more sales or paying more in bonuses.

Debt complicates the process of breakdown. You won’t just wish away that debt if you need to close your shop. Because the financial institution is a vendor, they are ranked first. In addition, the debt may cause you to try to cling on when you should have given up, creating a vicious cycle.

Debt gives the signatories mental worth. Even if you’re certain it’ll be paid off, you’ve implanted a tumour in the back of your mind that won’t go away until the last payment is completed. It affects your decision-making. You must keep debt payment in the forefront of your mind at all times, or the bank will not allow you to do so. It alters the way you do business.

Start with no debt from the beginning, and your business will function far more smoothly if you’re buying an existing business, set up an owner financing deal based on the company’s profits, or a percentage of the sales if your margins are high enough.

While arithmetic may work for leverage, it does not account for tension or anxiety.