Falling into a debt trap, Unknowingly

A valuable lesson I have learnt as an entrepreneur over the years is that starting and managing a business is not just about having a great product or service. Yes, those are essential, but it is impossible to keep a business running without capital. Hence, if someone comes to me with a business idea and asks my advice, one of my first questions to them is, how will you make sure that you don’t lose money?

As we all know, two of the most common ways entrepreneurs finance a new business is through equity or debt financing. Not everyone gets access to external equity neither does every entrepreneur look for equity to fund the company’s growth. Debt, in itself, is not a bad thing, but if your company is not yet in the correct phase to service that debt, you could find yourself losing money faster than you are making it. This is where new business owners need to be careful. Let’s examine a few situations where you could be putting yourself in debt but not necessarily in a position to pay your lenders back.

Very early on

Taking debt in the very early stages of your business might not always be the best decision simply because the level of risk at this stage is very high. Your business model might not be evolved enough to bring in the kind of cash flows that you are hoping for, which could make it difficult for you to fulfill your debt obligations. At this stage, it might be better to opt for equity even if it means giving up some stake. Remember that presenting an airtight pitch to your investors is as important as having a great product/service.

The quest to increase market share at all costs

We have seen that many companies indulge in ‘discounting’ to acquire customers and increase market share. For instance, if the product costs $2 but you offer it to customers at $1 thinking that you will be able to sell more, the $1 deficit has to be made up in some way, in other words, someone is funding it (investors, founders, bank). Unfortunately, entrepreneurs have several examples of such companies who resort to this model of customer acquisition and fall into a debt trap without realizing that a majority of such companies are well funded (it is another story on whether discounting is a sound business practice regardless of the quantum of funding, maybe another post some other day!).

Service and delivery failure

The crux of a business is to deliver top notch solutions to your customers, regardless of whether one is a products or a services company. The monetary gains in return for these products and services is what keep the business going. However, if you are unable to deliver on your commitment consistently, you could very well find your business losing customers. This could put a halt to cashflows. You, however, would still have your team and business infrastructure to maintain, for which, you would need cash. Finding investors in a situation where you have no customers might not be easy and hence, you might choose to opt for debt. Having a sound business is a pre-requisite, seems obvious but most entrepreneurs cannot separate the business from themselves and continue to run the business regardless of the financial position the business finds itself in.

Financial mismanagement

This is an important one to look out for. Oftentimes, in family-run or founder-run businesses, promoters/founders could find ways to make money out of the business, not through legit means. They might do this through relationships with suppliers, create fictitious employees, or find multiple other ways in which cash could be siphoned off from the company. The business could find itself in a situation where it has run out of money and might need to opt for debt while the promoter/founder is personally wealthy. This comes from a lack of distinction between the promoter and the business. Given that the promoter has founded the company or has been a part of the founding family, they believe that doing this is par for the course without realizing that this would lead to the business’ and their own downfall eventually.

Unforeseen circumstances

COVID-19 is one of the best examples of this. Several businesses for instance found themselves in a situation where orders were placed and were ready to be fulfilled when the pandemic hit. Several customers backed out, stating lack of funds, leaving businesses with inventory that they could not liquidate. A number of companies could not survive the pandemic. There are those who survived but had to borrow heavily and are still not out of the woods even after 2 years of the pandemic

Working Capital

Payment delays are more common than people realize. A business could find itself in a situation where it needs to pay its suppliers within a certain time period, say 30 days, but customers take 60 days to pay for the products. This 30-day delay could lead to a business scrambling for funds to meet its payment obligations. When a business has used capital to produce the product but it takes time to sell and recover those costs, they could find themselves opting for debt financing to tide through them.

As one can see, there can be several reasons why a company ends up borrowing. While most situations can be controlled, some like the pandemic are not entirely under one’s control. Being aware of these situations and being conscious could help a business make the right calls and avoid the ‘debt’ trap