Why is funding losses in your business with debt a bad idea? First, there are always two options when funding your business, one is with debt and the other is with equity. But many business owners would prefer to take the money out of their line of credit than take it out of their own pocket. Here’s the downside of taking debt in this situation.
1) If your business is losing money, it is likely strapped for cash. The cash you do have is likely going toward paying operating expenses or vendors. Borrowing money requires monthly payments of interest and sometimes principal. If you don’t have the cash to pay your expenses and vendors, how are you going to pay the lender?
2) Most lines of credit have a specific purpose mentioned in the commitment letter that the funds will be used for short term working capital and, often, a 30 day annual payout is required. That definition does not include funding operating losses. Generally, when you’ve used the line to fund losses you will have a balance outstanding that you can’t repay and you’ve accidentally violated the 30 day annual payout requirement. Violating the terms and conditions of the line of credit could constitute an event of default and you could find yourself in a situation where the bank demands payment on not just the interest, but the entire principal balance too.
3) When you fund losses with debt, your debt is increasing and your equity is decreasing because you’ve incurred losses. This creates a double whammy on the balance sheet, which increases leverage at a rapid rate. If losses take the net worth of your company down to zero where your stock has no value, the company can still have outstanding debt to be paid. At that point, you would have to liquidate all the assets just to pay back the debt. If you signed a personal guarantee, then you may have to liquidate personal assets to pay the bank if there’s a shortfall of business assets.
If you incur losses, a better option would be to self fund the losses with additional capital that won’t have to be repaid or take on an investor where you give a percentage of the company to receive the investment. Most business owners don’t want a partner, so self funding might be the better option.