Leading Entrepreneurship

Banks and investors couldn’t really look for the same amount of ROI… could they?

Let’s take a look at an example, keeping in mind that for a majority of small businesses, ROI = ROE = IRR (or there about).

If $100,000 is required to start, and $80,000 is borrowed from the bank, the debt service payments would range from around $14,500 (7% interest over 7 years – an equipment loan) to about $21,500 (12% interest over 5 years – a working capital loan). Thus, the return on investment required to service the debt would need to be 14.5% to 21.5% (annual debt service payments / $100,000). However, for a startup, a bank will typically look for cash flows of 3x debt service to feel comfortable, or the equivalent of a 43.5% to 64.5% return.

Startup Firm:
43.5% – 64.5% ROI for 3x debt service
14.5% – 21.5% ROI for 1x debt service
29.0% – 43.0% ROI to owner after debt

Some may notice that the bank is looking for similar returns on invested capital as an investment house. This forces the owners (after debt service) to generate levels of return similar to what a private investor would expect (typically 30-40%).

Interestingly enough, the math works for existing businesses as well, where banks often require a 2x debt service coverage ratio.

Existing Firm:
29.0% – 48.4% ROI for 2x debt service
14.5% – 21.5% ROI for 1x debt service
14.5% – 26.9% ROI to owner after debt

Here, you may notice that when the firm is established, the lender looks for typical private investor returns. After debt service, percentages are fairly equivalent to typical expected owner/operator returns. As a matter of fact, when appraisers value the owner’s discretionary cash flows from a firm, this is the typical range quoted.

Good for the bank, but good for you as well.