1) Don't
borrow unless you need to. Don't just take on debt unless you have a plan on how
to use the funds to grow your business. Do some projections or get your
accountant to help you compute how the financing will help your business.
2) Seek out the lowest cost
lender. Banks are the most logical source of financing - but they are often
unwilling to lend working capital to ISOs.
Typical lending rates:
|
Source |
Bank |
Venture Capital |
Mezzanine Financing |
Friends & Family |
RFC |
|
Typical Rate |
Prime+ (usually unavailable to ISOs) |
30% to 50% APR |
20% to 30% APR |
Incalculable |
Mid to high teens |
3) Don't borrow more than you need. You don't want
to take on unneeded debt burden unless you have a productive use for the money.
With RFC, you can always borrow additional amounts if you need it later merely
by executing an new Note.
4) Be conscious of the loan
term (the number of months that your payments will continue). A longer term
results in more interest charged but also produces a smaller monthly payment.
Visa versa, a shorter term
results in less interest paid but a higher monthly
payment. For example, below is a breakdown of monthly Payments (PMTs) and total
interest paid (gross and after tax) for a $25,000 loan at 15% APR:
|
Term |
12 months |
24 months |
30 months |
36 months |
|
Monthly PMT |
$2,256.46/mo |
$1,212.17/mo |
$1,004.46/mo |
$866.63/mo |
|
Total interest paid on loan |
$2,077.52 |
$4,092.08 |
$5,133.80 |
$6,198.68 |
|
Net after tax interest paid using 40% |
$1,246.51 |
$2,455.25 |
$3,080.28 |
$3,719.21 |
|
Effective after tax borrowing rate |
9% |
9% |
9% |
9% |
5) What about selling part of
my portfolio? Selling part of your portfolio has been the traditional way to
obtain working capital. However see below about
Debt Financing as to how
expensive that technique really is.
6) How long will the process
take? A sale of a portfolio can take a long time to negotiate. A loan from a banks
or other lender can also be a long process. RFC promises to complete the entire loan transaction in less than 30 days.
7) Use your advisors. Ask your
accountant or lawyer to help you figure out what is the best solution. It is
always good to get input from a specialist and a "second opinion" on your growth
decision.
The Power of Debt
Financing
A business' ability to grow often depends
on its access to "working capital". Historically, ISOs have had
difficulty obtaining working capital. Often, ISOs sell off their portfolios
to get the money they need.
But think about it: Does it make sense to sell
your business to "grow" your business? Not only is this counter-intuitive,
but selling is also 30% to 60% more expensive
than
debt financing.
Example: Assume two ISOs each have a portfolio producing $20,000 residuals per month. At a
20x multiple, each portfolio is worth $400,000. Each ISO needs $120,000 in working capital
for a growth opportunity.
Seller: To get $120,000, Seller must sell off $150,000 of
this
portfolio ($7,500 in monthly residuals[ $150,000 ÷ 20]) to get the needed
$120,000 (approx. $30,000 goes to the IRS as capital gains netting the ISO the
needed $120,000). He has sold a
bunch of his merchants, lost merchant compounding and merchant referrals, has gotten his
needed money BUT he is still short
the tax expense of $30,000. As you can see from the graph below, the Seller's
portfolio valuation (based on his residuals) declines 37.5% when he sells off his
stream, is still -25.3% below where he started by month 12, by month 24 he
is still -10.7% below where he started and has only gotten back to his
starting point ($400,000) by about month 34!!
Borrower: The other ISO borrows the $120,000,
sells none of his merchants, loses none of his residuals or
valuation, and sees his residual based valuation grow from the start.
The charts below show this dramatically:
Testing the "Sold" vs. the
"Borrowed" model using the $120,000 example above at months
12, 24 and 36, the data shows the superiority of borrowing:
| |
End
of
month 12 |
End
of
month 24 |
End
of
month 36 |
|
Net
Cash Flow Results: Residuals + growth - PMTs + tax benefit of interest deduction |
|
Net
cash flow: Borrowed model |
$20,030 |
$24,585 |
$30,036 |
|
Net
cash flow: Sold model |
$14,945 |
$17,869 |
$21,364 |
|
Benefit
under borrowed model in $$ |
$5,085 |
$6,717 |
$8,672 |
|
Benefit
under borrowed model in %% |
34.02% |
37.59% |
40.59% |
|
Valuation: Gross Residuals x 20x
multiple |
|
Borrowed
model: Gross Valuation ("selling" price) |
$478,247 |
$571,801 |
$683,656 |
|
Sold model: Gross Valuation ("selling" price) |
$298,905 |
$357,376 |
$427,285 |
|
Benefit
under borrowed model in $$ |
$179,343 |
$214,425 |
$256,371 |
|
Benefit
under borrowed model in %% |
60.0% |
60.0% |
60.0% |
For additional detail, you can download a
spreadsheet in pdf format demonstrating the above examples by clicking on this
link.
|
