I remember discussing a property with a commercial real estate broker a few years ago. I was questioning the investment, and particularly the amount of risk inherent in the deal, when he proceeded to educate me in a rather dismissive fashion about how “smart businesspeople make their money work for them.” He emphasized that the path to success was formed by the enhanced returns made possible with borrowed money. “The key to this whole game,” he said, “is leverage.”
My reply was simple:
“When times are good, it’s called leverage. When times are bad; it’s called debt.”
But it was 2006, during the headiest days of real estate bubble, and my message was lost on him. He was looking for a sale, so the picture he was painting was a of a magical world where customers miraculously appear, spend boatloads of money, and never leave. As many (and I suspect even he) have learned in the past few years, the good times can prove ephemeral, rapidly changing into something else entirely. When that happens, the leverage that was working so hard for you begins to work against you. Your leverage becomes debt and crushes you.
Moving The World Until It Rolls On Top Of You
Archimedes is noted to have said: “Give me a lever long enough and a fulcrum on which to place it, and I will move the world.” The picture of Archimedes’ lever is one I always keep in my mind when evaluating debt. The bigger the lever (i.e., the more leverage you have), the more it crushes you and destroys everything you are lifting when the fulcrum supporting it (the economy, your industry, your job, etc.) gets kicked out from underneath it. As business metaphors go, it’s a really helpful one.
So, if debt is so dangerous, why use it at all? Should we just avoid debt altogether? Dave Ramsey would probably say yes, and I understand his reasoning. I would be more inclined to say that say debt can be useful but should be used carefully.
As entrepreneurs, we have to be comfortable with a certain amount of risk. If you have a great idea or opportunity, should you wait ten years until you have the cash to do it? Maybe, maybe not. For my own part, I know many successful franchise operators who have achieved business and financial success made possible through SBA-backed small business loans.
The question to ask is simple: if we take on this debt, and it all goes bad, where will we be? What is the worst case scenario? Once understood, this risk can be evaluated in the context of the potential reward.
The reality is that leverage makes you stronger; debt makes you weaker – and that is the potentially fatal paradox. Because everyone signs on for leverage, but most do not plan for the day when it becomes debt. We are not given crystal balls in business (hopefully, brass ones), but you do not need a crystal ball to know whether or not to take on leverage. All that you need is the foresight to say “what if” and to know that no one has ever been evicted from their home for passing up a business opportunity.
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Notes:
Archimedes’ quote: http://www.brainyquote.com/quotes/quotes/a/archimedes101761.html
For an interesting take on whether Archimedes really could have moved the earth with a lever, see here. http://www.buzzle.com/editorials/7-30-2004-57259.asp
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