First of two parts.
Interest rates and fees make up the most visible and widely understood costs of a business’ debt. But if the concept of “cost” is expanded to include risk—as I believe it should be—interest and fees represent only the tip of the debt-cost iceberg. The far greater, but much less widely appreciated, costs of debt capital are debt’s inherent risks of financial leverage and owners’ loss of control over their business’ destiny. These hidden but high-stake risks of debt are magnified in the pro dealer industry, where cycles of periodic declining profitability are woven into the industry’s fabric.
The No. 1 pro dealer killer during the Great Recession was significant business debt. However, it was debt’s hidden costs, not its interest rates or fees, that caused the lethal damage. Fortunately, you have the ability to mitigate these hidden costs.
Think of your business as an uncertain stream of future operating cash flow. When you raise debt capital, you split the business’ cash flow into two portions: a “senior,” lower-risk stream and a “junior,” higher-risk stream. Debt also divides your business’ capital structure and enterprise value into two portions: a “senior,” lower-risk debt portion and a “junior,” higher-risk equity portion. The lender contractually takes the senior capital structure position and cash flow stream. (The stream is used to pay interest, fees, and principal before any earnings can be retained or distributed by the business.) Your business retains the higher-risk junior equity position and cash flow portion.
This division is appropriate. After all, the lender is agreeing to a more modest, essentially fixed payment stream. In turn, the lender is allowing you to keep all the remaining profits and enterprise value and upside. The lender gets a lower expected return on its investment, so it requires lower investment risk. The business keeps all the upside/reward opportunity, so it retains the higher investment risk.
But what’s underappreciated among owners is that by dividing your business’ already uncertain enterprise value and cash flow stream, you greatly increase the volatility of the junior portion, creating the risk of leverage. Substantial debt creates a “heads you win big, tails you lose big” bet. If you’ve also personally guaranteed your business’ debt, you’ve essentially created a “heads you win big, tails you lose it all” bet.
Furthermore, as pro dealers, we operate in an industry where down cycles are inevitable. If you own your business long enough, you will eventually flip “tails.” Hence, the risk of leverage is greatly magnified in our industry.
The good news is that you control the risk of leverage in your business by determining how much debt to use in funding your business and its growth. Debt is not inherently bad. But owners must understand and respect that, all else being equal, the more debt you use, the more financial risk you take on. The key is to be conservative, so that when you inevitably flip “tails,” you may be hurt, but you will not lose.
In Part II, we’ll address debt’s other hidden cost: its structural features that cause business owners’ loss of control over their business and how to mitigate this risk.
-Matt Ogden is managing principal of Building Industry Partners, a building products-focused private equity investment and M&A/debt advisory firm that is a co-founding equity sponsor of US LBM Holdings. E-mail: firstname.lastname@example.org. 214.550.0405