The XBanker
Business Financing eXpert
What’s Your Hurdle Rate?
July 9th, 2008
My mother always taught me that “beggars can’t be choosers” and my father preferred the “don’t be penny-wise, but pound foolish” - either expression is fitting for this topic. In the last week, I’ve had three experiences that made me think about being wise when you need money for your business and understanding the concept of a hurdle rate.
My first experience was a discussion with a consultant to a portfolio of companies in various stages of their business - all with immediate capital needs. We were exploring potential solutions for these people. Most simply needed $50-100k to purchase inventory or to invest in new opportunities - getting the money is critical to their success. Yet, as I started asking questions, I was being shot down with every possible financing option. It was apparent that these business owners were looking for $100k for 2-3 years at less than 5% interest with no colateral and no personal guarantee and they wanted it now, despite their less than stellar credit.
The second encounter was with a start-up that has just been exploding out of the gates, but with growth comes greater demands on cash flow. Nevertheless, they needed a short-term, hard money loan. They were willing to pay 35% on the money for 5 days (that was their offer). What they failed to understand is that a lot of interest without collateral doens’t reduce the risk of a transaction. They initially balked at the collateral demands, but realized after some shopping that no one cares about how much future return they may get, if they feel that there is a big chance that they’ll lose their entire investment!
The final experience was a conversation with my neighbor, who is just about to land a couple huge distribution channels for his product. He called me minutes after he realized that he was going to need to figure out how to finance the inventory (FYI - your big retailers will want 60 day terms). We went through a handful of possibilities and he soon realized that he wasn’t facing the crisis that he thought he was. My advice to him was to start thinking about his hurdle rate.
I really didn’t pay much attention in my finance classes in business school, but I do remember the concept of a hurdle rate. Your hurdle rate is the minimum rate of return that you expect from a particular initiative. There are a number of ways to calculate this, but I’ll keep it simple: think of your hurdle rate as the return you could get elsewhere (an opportunity cost) or what your money costs you (your cost of capital). For instance, if I can get a 10% return by investing in the stock market, I should expect a 10% return or more from a comparable risky investment in my own business - so I might use 10% as the hurdle rate that every business investment needs to surpass. Another way to approach it, is if my bank line of credit has a 15% interest rate over a 1 year period, then 15% will be my hurdle or my cost of capital. As I analyze the return from a particular investment or expenditure, it better clear that hurdle.
This really isn’t rocket science (if an MBA can learn, anyone can :-), but it is an important concept. Rather than getting caught up in what interest rate you have, you need to be focusing on what return you can anticipate from that money. I want to pull my hair out when a business owner turns down an unsecured line of credit because the interest rate is too high (you only pay on what you use!). Don’t allow yourself to get caught up in the lowest rate game. Work to get qualified for the best possible rates you can, then turn your focus on making sound investments in your business that will produce a superior return - investments that will clear your hurdle. At the end of the day, it isn’t what you pay for capital that matters, it is what you can do with it!
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July 29th, 2008 at 10:11 am
Excellent !!!!
Excellent post…
T.Z
September 25th, 2008 at 7:05 am
Looking for a credit partner to help fund a 40 AC. R.V. resort on the west coast of Florida.Thanks, Joseph