Managing Small Business Debt

Debt is an unavoidable part of starting and running a business, and managing debt effectively has large ramifications for your business’s bottom line. It’s good to be on a firm financial foundation before you start your own small business, as inevitably your personal and businesses finances will become mixed. Half of small businesses fail in their first 5 years largely due to insufficient capital, poor credit arrangements, and too much debt . It behooves you to have minimal debt when you seek financing, as you will have less stress overall and will be able to put more capital in your business. This is rarely the case however, as 49% of small business owners are in major debt while 75% of startup capital comes from credit cards, bank loans, and lines of credit. Managing all this debt is difficult, and many entrepreneurs struggle to find an effective way to reduce their debt load. Let’s explore some strategies and principles to evaluate how you manage your small business debt.

How do we Manage Debt?

Debt is everywhere in the United States. For example, nearly 70% of Americans own at least one credit card and most have more than 1. However, most people don’t know how to effectively pay off their loans. The most effective way to manage debt is to pay off the loans with the highest interest rates first. Staggeringly, of those surveyed, only 3% of individuals allocated money in a near optimal way. Most individuals instead focus on repaying their smallest loans first, in an effort to reduce the number of outstanding loans they have. This is called being “debt account averse,” where instead of reducing your total associated cost of financing you focus on reducing the number of debt obligations you have. Why is this? There are three explanations for this behavior:

Prospect Theory: Individuals are much more sensitive to a loss than a gain of an equal amount. The urge to get accounts back in the black as fast as possible is greater than the urge to analyze interest rates and calculate the optimal pay-off plan.
Goal Gradient Theory: Individuals are motivated by a salient goal. For example, when coffee shops hand out free coffees after a certain number of purchases, they are encouraging you to buy more coffee than you normally would by using an artificial goal. People find it easier to pay off small debts first, and get more satisfaction from paying them off quickly.
The final reason is that people often don’t understand how interest rates work or how to organize an optimal pay-off plan. It’s hard to visualize how your debt load changes over time and its effects on your business.

Are you Liable for Your Business Debt?

Personal liability is always a complicated issue when it comes to small business. If you are currently handling liability issues with outstanding debt, it is always best to consult with an attorney to get advice for your particular situation. With that said, let’s take a look at typical arrangements you find in small business financing.

Sole Proprietorships and Partnerships

In this legal structure, you and your business are legally the same, therefore you are personal liable for all your business’s debt. Your partners are also liable for the business’s debt, and not proportionally—your creditors can take your partner’s personal assets to pay off all the business’s debts.

Corporations and LLCs

You and your business are separate legal entities in this arrangement. In theory, you have no personal liability for your business’s debts but this is not always the case. It’s difficult to build a perfect wall between your personal and business finances. Here are ways you can become personally liable for your business debt:

You’ve signed a personal guarantee for debt. Small corporations and LLCs have trouble finding credit due to the limited liability construction. Banks want assurances that an entity can and will repay their loans so they often ask for a personal guarantee. A personal guarantee essentially has you give up your limited liability so creditors can turn to your personal assets for debt repayment if necessary.
Offering property as collateral for debt. Banks often have small business owners put up their house or other property as collateral for loans, creating real risk that a business failure means losing your house and other important assets.
Signing a contract in your own name. If you are careless and sign a contract in your own name and NOT as the corporation or LLC, you will be held personally liable for the debt.
Using personal credit cards or loans to fund the business.
Fraud, misrepresentation, or sloppy record keeping. If you like on loan applications or failed to create a formal legal separation between you and your business, creditors will bring you to court and find you personally liable for all debt. This can be called “piercing the corporate veil,” where the court establishes you are using your corporation or LLC as a front to reduce liability, when in fact you are personally operating the business.

How to Reduce your Business’s Debt Load

There are a few different approaches to reducing your total debt load. The first and easiest is to raise and invest personal capital. Leveraging your personal wealth or reaching out to friends and family can be a useful short-term solution to financing issues. Another important part of reducing your debt load comes from efficiently cutting costs. Analyze your balance sheet closely and determine where you can make the necessary cuts to meet your debt obligations. It’s often useful to contact both your customers and your suppliers in an effort to drum up business by offering deals on your product or service, negotiate cheaper contracts and payments, or try to reduce your accounts receivable turnover. Additionally, reach out to creditors if you are struggling to meet your debt payments. They’ll help you refinance your debt or consolidate all loans into one payment.
If you’ve tried all this but can’t seem to make the math work on your loan repayments, there are some measures of last resort you can turn to. Let the business fail and file for bankruptcy. Click here to learn more about bankruptcy options available to small businesses (http://www.nolo.com/legal-encyclopedia/chapter-7-chapter-13-bankruptcy-small-business-owners.html). You can also sell the business and liquidate all its assets to pay off debts if you’re not too highly leveraged. Hopefully, if you learn how to manage debt effectively, you will never have to be in this scenario.