A time to borrow? The pros and cons of adding debt

  • March 17, 2016
  • James Careless

Debt is a fact of life for solo and small firms which, like any small business, sometimes need somebody else’s money to help pay the bills. Too much debt, however, can outstrip a firm’s ability to pay, and put it out of business. The challenge is finding the right balance.

There are many good, supportable reasons for taking on debt.

“For instance, going into debt can help a new lawyer pay off their student loans and set up their practice,” said Alan Acton. He is vice-president and portfolio manager at Polaris Wealth, an Ottawa-based financial advisor that specializes in helping lawyers. “Frankly, unless they have access to family money, debt is vital to helping new solos and small firms get off the ground.”

Debt can also help solos and small firms fund equipment acquisitions or office expansions, and even the hiring of new staff to serve a big, new client who will over time rack up thousands in billable hours, if not at the outset. Without using debt, it might not be possible to take advantage of such opportunities.

There are all kinds and forms of debt available, including lines of credit, business and personal loans, mortgages, overdraft agreements on bank accounts, and credit cards.

Equipment suppliers will often offer leases as well. A lease allows the buyer to pay off the purchase price over time directly to the supplier, rather than by taking out debt from a third party lender.

Of course, all debt comes at a cost – that’s how the lenders make money. So the task for solo and small firms is to rate available debt options in terms of how much interest each one charges. The goal is to find the cheapest option and apply for it first, and then go from there. (New lawyers may want to apply first at the Bank of Mom and Dad. It usually has the best payback terms and fewest penalties.)

“Bank/trust company lines of credit are often the best choice,” said Acton. “They typically offer the lowest interest rates, and you can pay them off as you go; subject to meeting the LoC’s minimum monthly payment.”

The dubious honour of worst choice goes to credit cards with their double-digit interest rates and over-limit penalty fees. “You can be looking at interest rates of 20-30 per cent if you finance using credit cards,” Acton said.

Between these extremes are a number of debt options; including credit deals (term debt) that are negotiated directly with the bank. The downside of term debt can be the covenants attached to such indentures, which can limit the actions borrowers can take when they are close to hitting their credit limits.

“In such situations, a covenant may compel the borrower to paying down the debt, instead of making payouts to the firm’s partners or using those revenues to fund working capital,” said Andrew Luetchford; Corporate Finance Partner at the financial advisory firm Deloitte. “The problem here is that covenants can restrict a firm’s freedom of financial choice if the lender perceives the borrower’s debt level as being too high.”

Then there’s the special case of contingency lawyers, who don’t get paid unless they win the cases they’re fighting. Unfortunately, contingency lawyers have to cover their bills on time just like anybody else. This is why they turn to firms such as BridgePoint Financial Services, which bills itself as “Canada’s leading provider of lawsuit settlement loans.”

“We provide working capital to contingency lawyers, assessed on their caseloads and their likely case outcomes,” said Stephen Pauwels, BridgePoint’s Co-Founder and Principal. “They conduct their businesses using a unique financial model that we understand and know how to support.”

BridgePoint’s interest rates are higher than a standard line of credit or a bank loan (12-18 per cent, depending in the firm’s record and contingency cases involved) because the firm is sharing the risk that contingency lawyers face on a daily basis – a risk that few banks would underwrite.

Debt can get out of hand even at the best-run firms. A key case can go wrong, clients can pay late or take their business elsewhere, or the economy can crash and kill billables: cash flow problems happen.

Sometimes there are warning signs before the fall. “If your lenders demand substantially higher interest on your next loan, and/or demand a personal guarantee against your home or car, that means they are getting nervous about your financial state,” said Acton. “If this happens, you should be getting nervous too – and do something about it.”

If debt does get too high, solutions include paying it down by reducing expenditures elsewhere in the practice, plus restructuring debt with your lenders’ approval to get it under control. “This is where professional advice from a firm like Deloitte can help,” said Luetchford. “We understand the financial challenges solo and small firms face.”

When considering what cuts to make, look at those that will minimally affect your ability to earn money. For instance, replacing a full-time office with a corporate suite rented by the hour (the rest of the time you work at home) can cut costs while still providing a suitable venue for meeting clients. In the same vein, it may make sense to hire an administrative assistant at comparatively low wages to handle mundane tasks, while you increase revenues by boosting billable hours.

If there’s a moral to this tale, it is that debt can be good or bad for any business. What usually makes the difference is not debt itself, but rather how your firm manages it.

James Careless is a frequent contributor to CBA PracticeLink.