“If you would know the value of money, go and try to borrow some”

When Ben Franklin coined this phrase, I do not think he was explicitly talking about the cost of capital; nevertheless, if you have ever raised capital—either equity or debt—then you know that others value their money quite highly.

There are periods of time (e.g., 2006-2007) where lenders have forgotten the value of money. In Franklin’s era most lenders were lending their own money, unlike today’s more complex financial markets where commercial bankers, investment bankers, and hedge fund managers are lending other people’s money. While these professional lenders should still exercise the same degree of caution as if it were their own money, in practice they can be swayed by many counter motivations. Recently, this has led to overleveraging across many asset classes. What started with the mess in sub-prime residential mortgages has now spread across every other form of debt, and we have given this reaction the title of “Credit Crunch.”

While people have debated whether the Credit Crunch is the result of a crisis of confidence amongst lenders or a shrinking of available capital, I say it is neither. The Crunch is simply the hangover we are all experiencing after the raging party where lenders forgot the value of money. Standards have returned, and in some cases the pendulum has swung back too far; however, in all cases this is the result of a collective realization that money is valuable!

Franklin also said “when you run in debt; you give to another power over your liberty.” As a lender myself, you might think it odd that I would continue to quote a man like Franklin, who was so opposed to debt. The fact is that he was right, but he did not paint the whole picture. Leverage can be a very powerful tool to fuel growth and accelerate return on investment. Moreover, debt in all its forms is significantly cheaper than equity, so if you need cash to grow your business, swearing off debt like Franklin is foolish. HOWEVER, there is no free lunch, and a more reasonable cost of capital comes at its own price, which Franklin termed giving power over your liberty to another.

Private equity firms have proven repeatedly that layering debt onto the balance sheet of portfolio companies leads to greater management discipline and focus on the bottom line. At the same time, we have seen many companies implode unnecessarily under the weight of too much debt. So if you are considering debt to fund your business, what can you take away from all this?

Never rely on a lender to tell you how much debt you can effectively service. Whether you are buying a home, levering your company’s balance sheet, or factoring receivables, if you are truly honest with yourself, you know better than any financier how much debt you can handle without threatening your liberty. A year ago you could have easily found a lender to underwrite a bridge loan on a raw land purchase or a cash flow loan at four times EBITDA or an asset-backed loan at 80% LTV. Today, you will be hard-pressed to find a hard money lender for land acquisitions or three times EBITDA for a cash flow loan or an asset based lender who believes a 3rd party valuation report for which you hired and paid the analyst. So where lenders too liberal last year and are they too conservative today? What you need to take away from this is that the answer to that question should be irrelevant to you. You must define how much risk you are willing to take with your liberty, and use this to determine how much debt you will ask to lend.

Too often I hear equity holders ask, “How much do you think you can lend over my bank?” or admit, “I’ll take as much as you are willing to give me.” I sympathize with the desire to take as much money as possible, but the risks of debt scales with the principal you seek. Ultimately, it is in your best interests not to overreach, even when your lender has forgotten the value of money.