Learn about the promises and pitfalls of running a debt-free company.
By Adam Wren
Running a debt-free business is en vogue these days, with successful corporations such as Amazon and Cisco being lauded for their conservative cash positions.
Of course, the post-recession economy has favored large companies, propelling many to record profits while small businesses continue to struggle. But operating a debt-free company, and being able to sit on a pile of extra cash, may be the new economic reality as sales remain stagnant and businesses are growing more slowly and smartly.
Indeed, there is a growing crop of small business owners becoming debt-free. The number of owners who have a business loan declined from 44 percent to 29 percent between 2008 and 2011, according to an NFIB’s Jan. 2012 “Small Business, Credit Access, and a Lingering Recession” report. Instead, owners are choosing to pay off debt and refraining from taking on new debt. Likewise, while 79 percent of owners polled say they carry business credit cards, only 28 percent use them as a vehicle for debt.
NFIB members like Rick Haller, Bob Rauch and Steve Feinberg are doing their best to steer clear of debt these days, bootstrapping their businesses and stockpiling cash. Here’s how they are running debt-free companies, handling any debt they do have wisely and building their cash reserves.
While no statistics exist to show exactly how many small businesses operate free of debt, we do know this: 3 in 10 small firms start less than $5,000 in the hole, according to the latest U.S. Census data. That’s hardly an overleveraged position. Yet, NFIB data shows 88 percent of small business owners report having credit outstanding or access to a credit card. So, something happens during a small business’ lifetime that compels it to take on debt.
One explanation is that credit has, over time, become cheaper. Interest rates in the 1990s and 2000s hovered between 4 and 9 percent, compared with rates in the 1970s and ’80s that averaged 17 percent. Just before the Great Recession, many small business owners were sucked in to taking the high-risk, high-reward path of obtaining, and sometimes maxing out, massive lines of credit. Some eventually leveraged themselves out of business.
That’s what happened to NFIB member Rick Haller. Up until the mortgage crisis erupted in 2007, Haller was at the top of his game, using credit to prop up his house-flipping business. Over the next year, though, he went through an experience that fundamentally altered his outlook on debt.
As the crisis peaked, Haller found himself—like many other small business owners who relied on home equity as a means of financing—in a financial jam. (At the height of the credit crunch, 24 percent of small business owners used their home equity to finance business activity, according to an NFIB study.) After years of successfully flipping houses and with credit drying up nationwide, the bank called his mortgage notes. And as the housing market hit bottom in Vail, Colo., Haller did, too.
“It was like someone turned the lights off,” says Haller, who suddenly found himself overextended, out of capital and under a mountain of debt.
Haller decided that starting a new business would be the only way to reclaim all he had lost. Of course, he didn’t have the resources to take out a startup loan. Even if he did, banks weren’t lending. So with just $600, Haller bought a beat-up, 1995 Metallic Blue BMW 540, set up a tent in an outdoor storage yard and got to work salvaging it for parts. He worked around the clock in his makeshift garage to make a profit on whatever was left of the vehicle.
Almost four years and 300 junked cars later, Haller has fought his way back from the brink. Now located in Oklahoma City, his NFIB-member business, Alpine Foreign Automotive, is generating enough gross sales off salvaged BMW parts to support his family and one part-time employee. More importantly, he’s doing it all without debt.
“I grow according to cash flow,” Haller says, which means he reinvests profits and doesn’t take on debt. Period. At the end of each month, Haller saves a portion of his profits to create an emergency fund so that he never has to rely on a credit card or business loan to pay the bills. He keeps operations lean by purchasing only the inventory he knows will sell and by avoiding interest payments on a credit card balance.
Borrow Responsibly, Pay Debt Quickly
For many small business owners, operating their enterprises without debt may not seem possible. They’ve been up and running for years, and may maintain several lines of credit.
Bob Rauch thinks he has a good answer to this predicament: Get rid of debt as quickly as possible. And if you take on debt, make sure you have a realistic plan to pay it off. It’s common sense, he admits, but not all that common in today’s bigger-faster-cheaper business world.
In Belpre, Ohio, hundreds of miles away from Haller and his Oklahoma City salvage shop, Rauch is running his own debt-free company, albeit with a less conservative approach. Rauch had worked at American Electric Power, an electricity provider to 5 million customers in 11 states, for 38 years as an employee. The NFIB member now owns two car washes and a storage unit outfit. He currently does not have any debt.
It hasn’t always been that way. When he purchased his first car wash in 1995, Rauch took out a loan for $125,000 to buy the location and supplies. After a few years, he paid off that business loan. Then, in 2004, Rauch decided to build his second car wash and took out a $500,000 loan—about 30 percent of which he received at a 3 percent interest rate. Cheap money, as far as he was concerned, but a lot of debt.
In 2008, as his annual sales climbed to $350,000, he was easily able to retire that debt, making him—and the business—debt-free. “The thing that makes me different [from other small business owners] is that I’m not comfortable with debt,” Rauch says. “But if it is necessary, if you get in debt, you get yourself out as quickly as possible.”
To pay off his half-a-million-dollar loan long before the 15-year term was up, Rauch took pains to keep his lifestyle simple. “You don’t buy new equipment you don’t need,” he says. “You don’t buy cars you don’t need. You don’t go on vacations you don’t need.” Being debt-free provided him much-needed security as the economy plummeted in 2008 and 2009, and as other businesses dropped like flies around him. (Editor’s note: Rauch also recently paid off a $100,000 loan he took out last year to expand his storage unit business.)
Both Haller and Rauch champion conservative approaches to debt, but demonstrate distinct differences: One avoids debt like the plague, while the other uses it when he has to.
NFIB Chief Economist Bill Dun-kelberg says that taking out a line of credit often makes sense for small businesses, provided they’re in a strong financial position and can find access to credit. Small business owners cited the inability to obtain credit as their third most-pressing finance issue behind uncertainty and sales, according to NFIB’s Jan. 2012 “Small Business, Credit Access, and a Lingering Recession” report.
“If you have a long-run view of your firm, it’s generally not optimal to run just on working capital alone, and especially since credit is so cheap,” he says. “You could get a good 20-year loan, and that guarantees you cheap costs of fund for 20 years.” However, he cautions, owners should borrow responsibly and specifically address how they will treat that debt throughout the loan’s term.
Looking back on his decisions to take on debt, Rauch recognizes things could have turned out differently for his car wash business if he’d been hit by a lawsuit or some other financial emergency. “If you run into an economic downturn or an unexpected financial hardship [and you have debt], you’re up the creek,” he says.
Small business owner and speaker Chris LoCurto travels the country speaking about leadership and business. A former right-hand man to Dave Ramsey, the financial guru based in Brentwood, Tenn., LoCurto says about one-third of the owners in his audiences are debt-free—and the other two-thirds wonder how that’s even possible.
The answer, says LoCurto, is to start small (like Haller did) and choose to grow without debt.
“You have to grow slowly,” LoCurto says. “Everybody wants to go crazy by getting big loans and going big. That is what causes so many businesses to fail, because they don’t know how to run their business, and they get in way over their heads.”
For Haller, the salvage shop owner in Oklahoma City, the calculation comes down to risk. After being at the mercy of banks during the mortgage crisis, he’s become unwilling to allow others to control his fate. And avoiding debt is his way of addressing both the lack of credit and the lack of certainty, two key problems facing small business owners right now, according to NFIB’s credit research. As long as he can keep overhead low and avoid taking out a loan, he can keep his profits and not have them consumed by debt repayment.
Steve Feinberg, who owns Appletree Business Services, a small bookkeeping and tax service in Londonderry, N.H., says avoiding loans is a smart approach.
“Debt kills many of my clients,” says Feinberg, an NFIB member and accountant who works with roughly 100 small businesses each year. Feinberg runs his own company without debt, though he has access to a $100,000 line of credit for emergencies. “The biggest problem I see with my clients is they get sweet-talked by a bank. They get a credit line and they run it up, with the idea that in the future, business will be better [and they’ll be able to pay it off]. And those are the kinds of people of who will never get out of debt, unless some [extra] money descends upon them.”
Haller is content to grow this business more slowly. Long past the days of doing business outside a makeshift tent, Haller now rents a $600-a-month warehouse to house his BMW parts business. He’s been saving for five years and plans to move into a sprawling, 5-acre facility soon. Gross sales are now $140,000 a year.
Even though business is strong, Haller recognizes he could be selling more if he had a line of credit. He could purchase a new warehouse sooner, acquire more inventory and hire full-time employees. As the company expands, though, he lets customers—not his outsize ambitions—determine his growth.
The benefit: “You get to sleep at night,” he says. “Every dollar you make goes to you, and not to the bank.”