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Equity Can Be Key to Expansion

Howard Scott |

Though these are tough economic times, many drycleaners still need to implement expansion and renovation plans. And for some, now may be the best time to do so — while the rest of the industry is hurting, and bankers are reluctant to lend.
One drycleaner recently told me that he wanted to replace his old equipment and remodel his main plant, as well as open two drop stores. Two competitors had just gone out of business, making it the perfect time to expand and try to establish marketplace domination.
Unfortunately, his bank wouldn’t lend him the money. He approached a second bank, but it was also reluctant to lend, and he shelved the idea.
Now, he’s one frustrated drycleaner. Whenever anybody will listen, he tells them about his problem: “This is the time I could really get ahead [and] become the No. 1 drycleaner in my market,” he says. “But lack of funding is stopping me. With two kids in college, I can’t spare two nickels personally. No bank will back me. I’m stuck where I am. It’s a damn shame.”
There’s more than one way to skin a cat, however. Many foreign-born drycleaners often have a network of monetary sources — they can borrow from their family members, friends, neighbors and the immigrant community at large. They can pursue their business plans and pay the money back as the investment pays off.
If that’s not an option, I suggest a similar avenue: If a drycleaner has a plan for growth and can’t get the money necessary from the usual sources, he or she can tap into debt/equity capital.
Debt/equity capital is loaned money with a half-debt, half-equity feature. It helps reduce lending risk by combining the loan with equity ownership, and it’s a novel financial approach that can woo potential investors who might say no to a conventional loan request.
“Diluting my ownership share? No way!” I can hear some readers muttering. “My business is my retirement.” But you don’t have to sell your soul.
Here’s how it works: Let’s say you need $100,000. Your deal is this: $50,000 of the loan will be cash debt, to be paid back at the rate of $10,000 per year for five years at 5% interest. The other $50,000 buys an ownership stake in the business.
If the firm was previously capitalized for $100,000, the lender who puts in $100,000 is now a one-third owner, since the business’ capitalization increases to $150,000 under the arrangement ($100,000 + $50,000 lender capital). He or she also holds a $50,000 IOU.
Yes, you’ve given up a third of your business, but what do you gain? You gain the opportunity to propel your business into its next stage of growth. If things go well, you’ll soon become a monopoly in the marketplace, and your $100,000 firm will be worth $500,000 in 10 years.
You’ll be able to draw more than double what you were making before the capital infusion, and if you sell the business in Year 10, you’ll get two-thirds of $500,000, or $335,000. If you hadn’t sold a one-third share of the business, it might be worth only $150,000. Are you better off?KEEPING CONTROL
The beauty of borrowing money in a debt/equity arrangement is that you don’t have to give a minority owner any say in running the business. He can’t stop you from drawing a higher salary. He can’t second-guess business decisions. He can’t draw money out, unless you issue dividends. In short, your lender/investor doesn’t have any power. You are the majority owner, and you have control.
For half a century, the Ford family owned exactly 51% of Ford Motor Co., because it wanted to retain control of the company. No one could tell the Ford family what to do. Now that the auto industry is collapsing, it’s a historical footnote, but Ford looks like it may be the only American automaker to pull through. And the principal holds: Own 51% of a company, and you can do whatever you want.
The debt/equity principle can also be used to launch a new venture. Start with $5,000 of your own cash, borrow $100,000 (half debt and half equity), and you soon have $105,000 in startup funds and a controlling interest in the new firm. That’s because the debt is ultimately your contribution, so you own $55,000 (your original $5,000 plus the $50,000 loan).
If this sounds like a fiscal fantasy, it’s the same plan I used in 1968 to launch my business. I was a 24-year-old college graduate with $2,000 to my name. My goal? To raise $25,000. I wrote up a business plan, sent it to relatives, friends of relatives, local business leaders in my hometown, and even college friends with a little extra cash. One by one, I approached each of my prospects and made my pitch.
I wound up getting nine investors and collecting $23,000 in contributions, all of them 50% debt and 50% equity. With my original $2,000, I now had $25,000 in capital and owned 52% of the business.
I opened shop, and the business grew. I paid off the debt to my nine investors in five years. Over the next six, I bought out seven of my co-owners and owned 92% of the firm. When I sold the business in Year 12 for $350,000, 92% ($322,000) went into my coffers. That’s much of the reason why I now have the time to write this column.RISK AND REWARD
What’s in it for the lender/investor? He or she gets to put his capital into a going concern. He or she will make money when the firm prospers, although a smaller amount than if he or she bought 100% equity. But the investment’s risk is reduced; he or she will see a return immediately in the form of debt repayment.
If you pay 5% interest on the money borrowed, it’s well above today’s market rates for savings accounts and CDs. On a $50,000 debt, your lenders will receive about $12,500 in the first year ($10,000 return of capital plus $2,500 interest). In five years, they will be paid off. Quick payback is an excellent feature of debt/equity deals — it keeps investors satisfied with immediate return on investment.
Of course, the key provision is that your lender/investor has confidence in you. He or she needs to believe that you will grow the money through good management and savvy business practices.
It’s the same expectation people have when they invest in stock. They buy equity shares in a company with the expectation that it will use the money to increase profitability, and that that skill eventually will be reflected in the market price of the stock.
You, too, must be confident that your plan is sound. You must know what you’re going to do with the capital infusion and have strategies to employ that $5,000, $50,000 or $100,000 to good advantage. Your confidence will show in your voice, face and body language as you explain the offer to your potential investors.
When I was a 24-year-old kid with a business plan, I had absolute confidence that everyone would be better off if they invested in it, and that the plan absolutely could not and would not fail. Armed with that self-assuredness, every prospect I approached agreed to put $1,000 to $2,500 into my venture, and it worked out better than I’d ever expected.
When you’re stuck, you have to find a way to become unstuck. Borrowing money through debt/equity financing may be the perfect strategy to see your expansion and improvement plans get off the ground.
 

About the author

Howard Scott

H&R Block

Industry Writer, Drycleaning Consultant, and H&R Block Tax Preparer

Howard Scott is a longtime industry writer and drycleaning consultant, and an H&R Block tax preparer specializing in small businesses. He welcomes questions and comments, and can be reached by writing Howard Scott, Dancing Hill, Pembroke, MA 02359.

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