Why Loans with a Rising Payment Schedule is a Bad Idea

If you look on page 35 of the July issue of Inc. Magazine the article submitted by the reader describes of his upcoming problem with the bank. No longer able to afford the monthly mortgage on the warehouse that houses his business, the owner decides to accept an offer from the bank in order to avoid foreclosure. The owners agreed to turn over the deed to the bank which gave them a five-year lease on the property in return. The terms of the lease however involved a stepladder payment schedule in which lease payments would be lower in the first 2 years but significantly increase in the last 3 years. In this case, payments during the first year was $35,000 but more than doubles to $80,000 during the fifth year. It is in year three that the owners realize that they cannot afford the $62,000 payment.

Although the terms of the agreement are definitely questionable on part of the bank a rising or stepladder payment schedule in general is a bad idea. The same applies for any kind of loan product whether for business or residential purposes. The problem with a stepladder loan is that it hinges upon your ability to grow your business at a pace that allows you to comfortably meet your loan payments. Most business owners however significantly underestimate the amount of revenue growth needed partly because a company’s variable costs will rise every time there is an increase in revenue. The example above is a stepladder loan taken to extreme.

As a simple example, let’s just say you own some type of service business and your gross overhead expense is 50%. Therefore for every dollar in revenue you generate it costs you 50 cents. Now let’s say you want to buy product X which costs $2. You can’t just reason that all you need to do is sell an extra $2 worth of services to justify the extra expense. Matter of fact in order to afford this expense you must sell $4 worth of services to justify the extra $2 expense since your overhead expense is 50%. If you apply the same reasoning to the above problem, you are talking about having to generate some significant revenue growth in a 5 year span in order to afford that $45,000 (43%) increase in rent in year five.

The point to be taken here is that no matter how tempting it is to accept a loan with a rising payment schedule, go with a loan with a fixed payment! You will know exactly what your payment will be from the very start and will do everything in your power to make sure you can cover the payment. This is every bit mental as it is physical. Think about it, wouldn’t you rather have to mentally adjust to one payment rather than to 5? Imagine, just when you finally can afford your loan payment along with your other expenses, you are forced to grow your business again because the loan payment will increase in a few short months. Sure we are all in business to grow but it would be nicer to grow with less stress in our lives?

The bank may argue the point that you will have more flexibility to manage your cash flow in the beginning and that your payments will increase as your business grows. Again this is true but can be very difficult to do. In my opinion the best payment schedule is one that has a fixed payment but your first payment is not due until 90 days. If you are disciplined you will be frugal with your cash in the early days of your business and only spend when absolutely necessary. Spending too much on unnecessary expenses is one of the fatal flaws of most beginning entrepreneurs. It is very tempting to spend the working capital you have simply because it’s there. Vendors will call on you, consultants will offer you services that claim will increase your revenues immediately or you just may simply splurge on a piece of technology that you must have but don’t need.

The other major advantage of a fixed payment schedule is that you will simply build equity in your business routinely unlike a staggered loan in which the interest will be “top heavy” in the beginning and you build most of your equity in the latter part of the loan. This is a significant point just in case you need to refinance or take out another loan. You simply will look much better on paper.

With a graduated payment loan you just never know what lies in the future. Could anybody have ever predicted that we currently would be in a recession with double digit unemployment, rising foreclosure rates and rising taxes? Now imagine having a loan payment that will increase by 20% while at the same time revenues are dropping by 30% as a consequence of the recession. Unless you have a large cushion of savings, most businesses can’t afford a major fluctuation in revenues and expenses, matter of fact many can’t even afford a minor fluctuation. The combination of stricter bank lending requirements and negative equity in your business provides the final punch which may put you out of business because you can’t get a loan to get you through this difficult time. Having successfully repaid back not one but two business loans both with graduated payment schedules concurrently, I can tell you from experience that I made the wrong decision and that I would have saved myself a lot of stress and money if I had chosen a loan with a fixed payment. In hindsight the money I spent on unnecessary expenses would have covered the higher but fixed payment during the early days of the business. If anything I just did not have the forth sight and confidence. Learn from the mistakes of others. If your situation makes good business sense be confident and go with the fixed payment loan.

When Doctors Think They are Great Businessmen

I grew up in a family of physicians in a small town in West Texas. Many of my neighbors were also doctors of some sort and in their own right were very successful with regards to their prospective professions. I was always amazed by their intelligence and their ability to cure people of their illness, especially the surgeons. I thought these guys are smart and really making a difference.

However the very nature of their intelligence and success ironically was also their downfall at least from a business perspective. In comparison to most other professions doctors have always been at the top of the earning’s curve. Only your mega investment bankers, CEO’s and hedge fund managers bring in much higher paychecks. In any case the earnings of a doctor can provide for a nifty source of investment capital as was the case when 4 of my neighbors who were all physicians decided to pool their money together, raise more capital from other investors and buyout a struggling vending machine company that made hot French fries. Just like a soft drink vending machine, you would put money into the machine and in just a few minutes it would pop out hot french fries. At the time this concept was a novel idea but the technology to make this seamlessly work was way ahead of its time. In total $15 million was raised to buyout the company much of it from the original investors. An oilman who lived in the neighborhood also kicked in a substantial amount of capital. The company was essentially a start up and had no revenues and only a prototype. However it already had the overhead and expenses of an established company. In a few short weeks my neighbors bought out the company called KFI International. The story made front page of the local news paper and all of a sudden not only were my neighbors known to be great doctors but also hailed as great businessmen.

At the time I was 17 years old and although I had a fascination for business I did not quite understand what it actually took to run and grow a company. Little did I realize that I was getting a first class real life education in how not to buy a company.

About 2 months after the company was bought out a meeting was called at the company headquarters in Colorado Springs, Colorado. People in attendance included company executives, franchise owners and the new owners of the company. Not in attendance was the previous and sole owner of the company which I will not name. When asked about why he was not in attendance I was told that he went back to South Africa as soon as the company was sold, $15 million check in hand. I found this rather odd but then what did I know.

When I arrived at the company grounds, I noticed that the two story building resembled a large log home that blended well with the scenic back drop. I also noticed that there were five bright red BMW 530’s parked side by side as well a full length decked out recreational vehicle with the company logo plastered on each side of the RV. I asked one of the investors who owned all those BMW’s? He responded that they were company cars as well as the huge RV. There was even a company lear jet. To a 17 year old all those fancy modes of transportation was pretty cool especially the jet but as you probably suspect those fancy modes of transportation were nothing but a bunch of red flags.

After the meetings ended on Friday, we drove the next day to Cheyenne, Wyoming to visit the manufacturer of the vending machines. What we saw was the prototype as the machines were not ready for mass production. Matter of fact the manufacturers could not even get the prototype to work that day. But hey we did have a fancy brunch with the CEO of the company afterwards. How cool was that, a 17 year old sitting next to a CEO talking business. When the check arrived, I noticed that we had to pay the bill. Funny I thought, should not the CEO be wining and dining us since we were paying him a lot of money to make the vending machines?

The company had been set up as a franchise operation in which franchisees would own the legal rights to develop a certain territory. KFI International would earn revenue by leasing the vending machines to franchisees and getting a small cut of the revenues generated by the vending machines. The company also generated revenue by charging franchise fees to develop those territories. When the company was bought out about 35 franchisees had already paid the franchise fees to KFI and were simply waiting for the machines to be developed. It turns out that the $15 million price tag only included the prototypes. We still had to pay the manufacturer a bunch of money when the machines were ready for mass production. In order to do this we had to raise more capital and find more willing investors. Several months went by and unfortunately we found no takers. About the only development worth noting was that company headquarters was moved to Dallas, Texas mainly because the COO lived there. The new headquarters were much more modest.

It was then I started to ask myself what in the world did they exactly buy for $15 million. There were no machines but yet there were company cars, an RV, fancy looking digs and yes the cool lear jet. I guess they did buy a brand, thirty -five ready-to-go franchisees and the patent technology to developing the vending machines but other than that did they really buy anything of value to the company? There were no revenues, a company that was fully staffed (which meant inflated salaries had to be paid) a product that still has not been developed and thirty-five paid franchisees waiting patiently for the machines to be completed.
Almost a year went by before the prototype was finally ready for mass production but unfortunately my neighbors were unable to raise any more additional capital for mass production to start. To keep the company going during that year they sold all of the outlandish and unnecessary luxuries except one BMW (they should have sold all of them) and used the cash for salaries and business development costs. By September the layoffs began and by Christmas the company declared chapter 11 bankruptcy. There was one last attempt to raise money during late February the following year and when that failed the company declared chapter 7 bankruptcy. I noticed during that Christmas season none of my neighbors decorated their homes with those flashy red Christmas lights. Their entire investment was lost.

As I reflect on this story, I have nothing against doctors who want to give entrepreneurship a try. If you look at the Forbes 400 of wealthiest people in America some of the people on that list are former practicing physicians. The most notable doctor is Philip Frost, MD who has been on the list for many years. Matter of fact I encourage doctors of all types to be entrepreneurial. To the minimum being entrepreneurial will at least help their professional practice succeed from a business standpoint. If they decide that they want to venture off beyond the scope of a traditional practice I offer the following advice:

1)Put your ego aside. Just because you sport an MD or DDS degree or whatever does not mean your intelligence will ensure you a greater degree of business success.

2)A larger paycheck basically just means that you have more to lose. Invest that money as if you were only earning minimum wage.

3)Don’t be left holding the bag. If an investor comes to you with an exciting investment opportunity there’s a chance that the smart money has passed on the opportunity and so the next best thing are the doctors since they have money and are eager to sometimes throw money at any opportunity that sounds half way decent. There are many genuine opportunities just be sure to do your homework and then some.

4)Don’t get suckered into the “herd mentality”. Doctors tend to feel left out and don’t want to miss out on the next big thing.

5)Your best chance of success will most likely be in something that relates to your professional practice and knowledge base. For example, much of Dr. Frost’s business success comes from the pharmaceutical industry.

6)Put your arrogance aside. Don’t insist being addressed as doctor. Bill McGuire the ex-CEO of United Health Care liked to be address as Dr. McGuire. Sometimes the business community will frown upon you simply because you are a doctor.

7)Consider getting an MBA. There are MBA programs catered specifically towards physicians and dentists in which you can maintain a full work schedule while going to school. An MBA won’t ensure automatic success but it can increase your chances being that you come from a medical background.

8)Insist on a board of directors or an advisory board with experienced business people especially within your particular interest. Don’t form an advisory group full of other doctors. Get help and communicate with these people regularly.

9) Spend money to hire the right people in the beginning to help you, it will save you a lot of money and headache in the long run-maybe prevent you from losing your entire investment.

10)Don’t think you know it all. Don’t think you can do it all. Matter of fact you don’t know a damn thing.

11)Make sure you have the support of your significant other especially if you have a family.

12)If you fail pretty much the entire hospital is going to gossip about.


As for my neighbors their biggest mistake was that they did not know what they were buying and did not hire the right people to perform the due diligence. They bought a company that had spent money on all the unnecessary luxuries before there was even a hint of any revenue much less a proven product. For many years my neighbors did not talk to each other after the company went belly up. One even moved to another part of town just so that they would not have to cross paths on the same street. Luckily they all recovered financially and in time the whole ordeal was pretty much forgotten by all -10 years later.

When the Sheriff Shows Up at Your Door

As I read an article entitled The Tax Man Seized My Business in the April, 2008 issue of Inc. Magazine, I am reminded of a similar incident my business went through.

We had just recently completed the construction of our new office, a veterinary clinic to be exact as well as the installation of operatory equipment needed to perform procedures and take x-rays. Without this equipment we could not treat our patients, which meant there would be no revenue which meant we could not pay our bills.

We had hired a real estate consultant to manage the project and assist us with providing an estimate of the total cost of the project. The real estate consultant had referred a general contractor to us whom he was familiar with to provide the estimate. This estimate was going to be submitted to our lenders whom we already had an ongoing business relationship. The general contractor estimated that it would cost approximately $150,000 to construct the 3000 sq. ft. office which was located in a gutted out retail plaza. To equip the office would cost another $85,000. We submitted a request in the amount of $235,000 to our lenders and were approved. Negotiating with two separate lenders, one to finance the construction and the other to finance the equipment would prove to be a key decision as I will explain later.

In the meantime our real estate consultant interviewed three other general contractors and invited them to submit bids for the project. What we were told next was nothing short of a rude awakening. The three additional bids were all at least $265,000 for the construction of the clinic alone and did not include the cost of the equipment. Construction of the clinic without the equipment was useless. We asked our consultant why there was such a huge disparity from the original estimate? He informed us that general contractor that he recommended had significantly underestimated the cost of the build out and realizing their mistake quickly withdrew their bid. A week later we fired our real estate consultant.

We contacted our lenders and informed them what had just transpired and requested additional funds in the amount of $115,000. Unfortunately our lenders would not approve us for any additional funds as they were concerned that we would be overleveraged and would not be able to meet our monthly debt service payments. We contacted several other lenders and were also denied. We faced a very difficult situation knowing that we were going to be short $115,000. Construction had already begun and pulling the plug on the project was not an option as we had to be out of our original location by a certain date due to the demolition of the building (the landlord had sold the building and surrounding land to developers). We also could not afford an interruption with the business meaning as we moved out from our original location on a late Friday afternoon we had to be up and running in the new location by the following Monday morning. Continued cash flow from one location to the other was a must in order for the transition to succeed.

Our only option was to proceed with the project. To decrease the amount that was still needed we contributed all of our savings in the amount of $50,000. This reduced the shortfall to $65,000. We were banking on the cash flow generated by the business to make up for the difference and were predicting an immediate increase in monthly revenues by 40%. Our growth rate for the last 3 years was 20-25%. We also negotiated delaying payments to other vendors. To be honest, we were operating on a whim and did not really know what to expect. You just had to put your best effort forward and deal with the issues as they arose.

Despite our efforts, the strategy did not work as the note which financed the equipment went into default six months into the agreement. A year and six months later, our equipment lender filed suit against us for non-payment. As it turns out we were fortunate to have negotiated two separate loan agreements with two different lenders otherwise a single lender would have started to foreclose on the entire business.

We quickly handed over the matter to our attorney and after 4 months were able to negotiate a settlement which included a monthly payout secured by a judgment. It was only after this agreement that we truly understood the financial health of the business. After only four monthly payments we went into default again as we were still struggling to get our expenses under control. Despite the set-back we remained focused on a solution to this matter and trusted that our lawyer could negotiate another agreement. This is where I discovered that having a strong and experienced attorney really counts especially when you really have your back against the wall. One of our biggest allies was time simply because the more time we had the better we were able to find solutions to control our expenses and cash flow. Our attorney was able to delay proceedings for months giving us valuable time to fix our problems and continue to grow the revenues. Another reason why you should have a good attorney is when unexpected surprises comes knocking at your door-literally.

After not hearing anything from the plaintiff for 3 months, they decided to get aggressive with us and proceeded with a writ of execution. Basically, the sheriff showed up at our door ready to repossess our equipment. Now when the sheriff shows up at your door unannounced, your employees start to wonder what is going on as well as your clients. You also start to develop a sense of hopelessness and discouragement because you feel that you are now really out of options. No more negotiations and no more stalling. Actually, you do have one more option, call your lawyer immediately which is what we did.

Our lawyer quickly drove to our place of business talking on her cell phone as she tried to negotiate with the plaintiff's attorneys. At the same time she was questioning the sheriff on the validity of what exactly he could repossess if anything. I am thinking, wow the sheriff is standing right here in front of me and my lawyer is telling him that he may not be able to take much. Trying to avoid getting into a legal ramble with my lawyer the sheriff stated that unless we give him $65,000 he would start taking equipment with a value totaling at least $65,000. Our lawyer quickly strategized as a stall tactic that if he took action he must only take equipment where the lender had a first lien position and could not take equipment in which another lender had a first lien position. Doing so would result in legal action against the plaintiff. Our lawyer used this line of reasoning against the plaintiff's lawyer and stressed the weak financial position of our business. Funds were limited and if the sheriff took the equipment a moving company would be hired and we would be stuck with the bill. Our lawyer posed the question to the plaintiff's lawyer, "do you want what limited funds my client has to go to a moving company or do you want it to go to your client"?

At this point my feelings of hopelessness and discouragement started to wane and I actually started to feel even confident that we may again dodge another bullet. Sensing that the plaintiff's lawyer may cave in, the sheriff approached me directly and asked me to show him where the equipment was located. In his mind he did not think that my lawyer was going to have any last minute success. In any case the sheriffs demand to show him the equipment was like a state trooper requesting to see your driver's license after he has pulled you over for speeding. You just do it. To my own surprise, I looked at the sheriff, paused for a few seconds and firmly replied "wait". I wasn't too sure how the sheriff would react to my answer if anything I was expecting him to be mad. As it turns out I did not have to find out as my lawyer was able to negotiate a last minute agreement which entailed an immediate payment of $2000 and re-instatement of our original agreement. Just 6 months later we paid off the entire balance.

In writing about this experience, the main point I want to make is that it is very important to develop a relationship with an attorney early on in your entrepreneurial career. As I read the article in Inc. Magazine, a comment was made by a reader stating that the owner of the ice cream shop could have avoided temporary seizure of his business by the state by hiring a good experienced attorney. The ice cream shop owner had hired his CPA and then proceeded to represent himself along with his partner. Hiring an attorney would have allowed him to continue operating his business saving him thousands of dollars in lost revenue.

Even in the most dire of situations, you can still avoid a major setback by partnering with the right people. Form a relationship with an attorney early on in your career and plan ahead. As soon as you feel (not when you know) that a potential legal problem will arise inform your attorney as she may be able to prevent the problem from escalating into something bigger and more expensive. As entrepreneurs we should focus our time energy and resources on what we do best, running and growing our companies. However problems, disputes and legal issues will always arise and when they do simply let your lawyer handle the issue. Doing so will help you keep your focus as well as your morale and enthusiasm. Yes you will incur legal expenses but in the end, the expense of your lawyer will be much less compared to the lost revenue and time if you handle the issue yourself.