When Avoiding Debt Is the Losing Strategy
I must have written a dozen articles about the dangers of debt, but there are circumstances where taking on debt is the winning move. Here's an analysis.
Borrowing for consumption is almost always bad. (I say "almost" only to allow for cases where you're borrowing for necessities like life-saving medical care.)
Borrowing for investment is another matter altogether. In a growing economy, refusing to use debt to grow can cost you your business.
Here's an example. (See also: Good Debt, Bad Debt)
Suppose you have $20,000 in capital and want to open a coffee shop. You get a lease on a storefront, buy a machine to make espresso and cappuccino, order supplies, hire a few employees, and open for business.
Let's further suppose that your business is a success. Right from the start you earn enough money to pay your rent, utilities, taxes, suppliers, employees — and have enough left over to support yourself. In fact, let's suppose you're making a little more than that.
Finally, let's suppose that you figure your town can support four, maybe five coffee shops, and that you start putting aside that little surplus you're earning with an eye toward expanding just as soon as you've saved another $20,000.
That's a reasonable-sounding strategy. But it's a losing strategy if you're up against someone who's willing to take on a little more risk.
Suppose there's another guy in town with $20,000 in capital, and that he also thinks there's room for four, maybe five coffee shops. But let's suppose this guy takes his $20,000 and goes to the bank and borrows another $80,000. Then he takes the $100,000 and opens five coffee shops.
If you're both right about the number of coffee shops the town can support, his shops may well be successes right from the start too. Like you, he can pay all his expenses. But whereas you're only taking home a little more than you need to support yourself, he's taking home five times that.
Now, granted, he's going to have to pay interest on his debt. But how much is that going to be? Right now, no more than 7% or 8% — call it $6,000 a year in interest. Even after paying his banker, he's still making a lot more than four times as much as you.
Now, this may all seem okay. I mean, he's making almost five times what you're making, but he's taking on a lot of risk, plus he's working five times as hard as you. You may figure he's earning every penny, and be pretty glad that you're not in his shoes.
Except for one thing — you both figured that there's only room for four or five coffee shops, and now there are six.
You can expect competition to get pretty fierce.
Advantage: The Debt-Fueled Guy
The problem is, the other guy can compete a lot more fiercely than you. You've got a little money to compete with — that surplus you were hoping would let you save up to open another coffee shop. You could spend that money on advertising, or you could cut prices until they ate into your profits by that much. After that, any further fall in your profits cuts directly into your standard of living.
Your competitor can cut his profits by 80% and still have enough support himself.
Your competitor has other advantages as well. He does five times as much business with his suppliers as you, so he may well be able to get bulk discounts that you can't. As a larger business that employs five times as many people, he may get extra consideration from the city council when it comes to regulations that affect the business — rules about putting tables out on the sidewalk or having live music or how the dumpsters are arranged.
The Role of Risk
Now, it's true that the other guy has taken on a lot of risk.
In particular, if you're both wrong, and the town really only has room for two coffee shops, he's probably screwed. He's got five coffee shops, and they're all losing money. Your coffee shop is losing money as well, but you don't have any debt. If you can find some way to bring a little money in — maybe getting a part-time job — you can keep your shop open for a good long while. Your competitor has no hope — he can't get a part-time job, because he's running five stores and has no spare time, plus he's got those interest payments on top of everything else.
But there's always risk in running a small business. Any of a thousand things could go wrong.
If you're a risk minimizer like me, you might be surprised to learn that one thing that could go wrong is that you're not willing to take on a bit of debt, if that's what it takes to get big enough to compete.