When to Take on Debt

When to Take on Debt
August 30, 2017 admin
In Podcasts

Ray Zinn, the longest serving CEO in Silicon Valley, is famous for having leveraged himself, and not venture capital, to launch semiconductor company Micrel. Ray discusses the situations that make initial debt financing a smart move.

Guy Smith: Good morning, everybody, and welcome to the Tough Things First podcast, where we pick the brain of Mr. Ray Zinn, the longest-serving CEO in Silicon Valley. Speaking of Silicon Valley, it’s another sunny morning here and good morning to you, Ray.

Ray Zinn: Thanks, Guy. I appreciate after all this rain, we get a little sun coming out.

Guy Smith: Rain is necessary for life and so we shouldn’t complain about rain too much.

Ray Zinn: No, I’m not complaining. I’m just saying it’s nice to get a little sun once in a while, though.

Guy Smith: I was looking up plans for an ark before it finally broke, and it’s about the right timing. One of the things I want to talk about, and this a constant source of fascination for me, is the subject of debt. I don’t like the stuff, personally, but when people are starting their own companies, they have to raise money. It’s nice to go after venture capital money, but you’ve been very clear about the downsides of venture capital. There are only so many friends and family you can pick on and so some people choose to go into debt. I know that leveraged yourself fairly significantly when you started Micrel over 37 years ago. Let’s talk about when people should consider debt in order to get their business started. What situations make initial debt financing a smart move?

Ray Zinn: Going back to my time when I started Micrel, I did not want to use venture capital and, certainly, I had no family members that I could rely on. My dad had just passed away and my mother was teaching school. I still remember my siblings were at home, and there was no family that I could go to, nor did they have the resources anyway to loan me the money.

That meant I had to either consider angel money, which is a form of VC, or to go to the bank. You remember, if you’re going to take on debt, if you’re going to go to a bank, they want paid back, so you have to have a profitable company. There’s no way you’re going to get a loan from a legitimate bank if your company is not going to be profitable. A lot of startups aren’t profitable. It takes maybe two or three years for them to hit profitability.

There may be a few opportunities for them to raise money if you put up what we call personal guarantees. If you put up significant assets to cover that debt, some banks are willing to give you a period of time, a grace period, to get the company to profitability so that you can pay off the debt, because if it doesn’t happen, they’ll just collect on those personal guarantees. The strength of a person’s net worth will determine how much the bank is willing to loan them.

Let’s say you have a $200,000 home and you had $100,000 in equity in the home, the bank will loan you probably $50,000 on that equity. That’s kind of the way it works. If you’re going to borrow money, you either have to have assets to support it, meaning that it’s almost like a personal loan, or you have to have your company profitability such that the bank can see you can make the payments on that debt. That determines, really, how much debt you can take on and what banks will be willing to loan you the money. Banks loathe to loan to startups because they’re not an ongoing business in their minds.

Guy Smith: I can see a trap that some startups might get in, where they accept venture capital up front, but they do become profitable and, to go to that next round of growth, they might want to consider debt financing, which would make a lot of sense. I bet you the venture capitalists that were in those early rounds pull out the large sticks and try to keep the CEO from leveraging the company through debt at that point. Is that factual?

Ray Zinn: That’s true. That is a point. If you’re with the proper venture capital group, doing a bridge loan or getting a loan is not something that is done regularly. The venture capitalists can’t force you unless they own the company. Unless they have 51%, they can’t force you to borrow money from them. Certainly, you have, as the CEO or the chief financial officer, you have the right, if you’re the primary holder of the company, then you can just go get financing wherever you would like. There are a number of ways to do that. There’s equipment financing through leasing, there’s typical bank debt, there’s revolving lines of credit, you can borrow against your receivables, so there are a number of ways that you can borrow money. You just have to look at what’s going to best suit your needs and your company.

Guy Smith: Being risk-adverse myself, I try to stay away from debt. I’ve got to imagine that there are certain moments during the growth of a company when debt would really be a dumb idea. When should a founder run away from debt? When should they say, “No, that’s the last thing I want to do?”

Ray Zinn: If you don’t need the money, obviously, there’s not need to borrow it. If your company’s not making money, run away from it. Banks will be all over you if you can’t make that debt service. They have the right, actually, to shut you down. They can push you into bankruptcy. They’re going to set is ss the primary holder of the debt and they can push you over the edge. They’re not going to mess around. They’ll give you a little leeway, but they’re going to be hounding you to start making the payments.

You’ve got to be profitable and you have to have a way to pay off that note. Being risk-adverse is fine, but that won’t help you borrow money. It’s a matter, again, how much debt you need to take on and for what purpose. That’s the other thing that the bank is going to be looking for, is where and how are you going to use this money.

Guy Smith: I’ve seen a couple of startups get into trouble by doing the opposite path on debt, extending a little bit too much credit to their customers and eventually getting into a non-repayment system. You spoke in your book, Tough Things First, about stall horns, financial warning systems that tell the CEO something really bad is getting ready to happen. When it comes to extending debt to customers, what kind of stall horns might a CEO put in place to make sure that they aren’t being a little too giving and a little too generous with customers?

Ray Zinn: That’s a good point, Guy, because the typical payment is net 30 days. That’s what we see as generally the case. If you’re extending credit to a company that doesn’t have good credit, you want to do letters of credit or you want to do money up first. I think one of the problems that companies get into is that they start extending credit to people they shouldn’t. That’s the warning sign, is don’t extend money to companies that can’t pay, or that they’re not likely to pay. That’s the stall horn that comes on. If you do a credit check, and you should, always do a credit check. If you do a credit check and that company does not look like they have the ability to pay, don’t give them the product, which is the same thing as loaning the money.

Guy Smith: Pun intended, but I think we’re all in your debt today for kind of marshaling us through these issues. Thank you for your time again, Ray, and to all the listeners out there, by all means, go to toughthingsfirst.com, connect up with Ray personally in social media, on Twitter, on Facebook, on LinkedIn. If you have not already, make sure to get that copy of Tough Things First. It is probably the best education you’re going to get in leadership management and just getting by in life in general.

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