100%-Leveraged Start-ups

Yesterday’s chat with fellow entrepreneurs was great for all the reasons I gave yesterday. I learned about the amount of financial leverage new entrepreneurs are using to start their companies. Using financial leverage is normal, but I was surprised by the amount. These founders are receiving 100% financing from banks for all their start-up costs. No business plan and no entrepreneurial experience required, either.

This blew my mind. It reminded me of the years leading up to the global financial crisis (GFC), when homeowners were able to take out 100% of a home’s price as a loan from the bank. They didn’t have to put anything down, so they didn’t have any skin in the game. Some homeowners were given stated-income loans, meaning their incomes were verified. What my friend described yesterday isn’t exactly the same as the GFC, but made me think of that period and the ensuing carnage.

One of the entrepreneurs yesterday shared that he’s starting to see these new entrepreneurs struggle. Inflation has materially increased start-up and construction costs, so new entrepreneurs must take out larger loans to get the company going. These larger loans have higher interest rates, compared to the previous fifteen years, so the amount of cash required to service the debt payment is materially higher. Prices these entrepreneurs can charge customers haven’t risen materially, so they can’t offset the higher debt costs unless they build a business that can service materially more customers (which requires higher start-up costs and more debt). Some of these entrepreneurs are having second thoughts and considering selling their businesses at a discount to wash their hands of the problem.

It was super interesting to hear about this from operators at the ground level of this industry. It makes we wonder if there’s too much leverage in the system that many people aren’t aware of.