The crucial money decision Elon Musk made when he was broke

In a span of less than four months, Tesla Motors (TSLA) founder and CEO Elon Musk has added $2.3 billion to his personal wealth . Musk is now worth more than $13 billion, according to the Bloomberg Billionaire Index, but it could have worked out very differently.

In fact, a crucial decision Elon Musk was forced to make in 2010 when, by his own account, the billionaire was broke, is one of the reasons Musk has been able to cash in on Tesla’s rapid share rise this year: Musk held on to shares at the very moment when a sale to raise cash would have made financial sense.

Musk, who had $200 million in cash at one point, invested “his last cent in his businesses” and said in a 2010 divorce proceeding, “About four months ago, I ran out of cash.” Musk told the New York Times’ DealBook at that time, “I could have either done a rushed private stock sale or borrowed money from friends.”

It’s a dilemma that many entrepreneurs face, but there is a big difference between the options available to Musk and the options available to most business owners. Musk was able to live on $200,000 a month in loans from billionaire friends — while still flying in a private jet — rather than sell any of his Tesla stake. Though the root of the problem is the same: intangible assets or, in other words, a business owner who is “asset rich” and “cash poor.” And it can lead business owners to the most difficult decision of all: having to sell a piece or even all of their company.

This is not a problem limited to founders of technology start-ups based in California.

“It’s really one of those tough scenarios with no good answers,” said Richard Stumpf, CFP and managing partner of Wichita, Kansas-based Financial Benefits. Stumpf has worked with farmers in this situation, and sometimes for reasons that are similar to what drove Musk to admit he was broke: divorce.

“It happens all the time here,” he said. “Farming 2,000 acres … asset-rich, cash-poor. And the options are limited, quite frankly.”

Even if you have friends as nice as Elon’s, borrowing money can cause problems. Years ago a friend of Stumpf’s, who owned a heavy road construction company, got into a bind and borrowed money from buddies. He eventually paid them back, but got behind and risked ruining relationships. In the end the business survived better than his strained friendships.

Even for business owners with collateral to back the loan, the cash flow needs to be coming in to meet debt payments. And in many cases lenders are picky about asset types they will accept. Intangible assets are not the type of collateral that a typical commercial lender will accept, said Andrew Sherman, partner at Seyfarth Shaw, who has worked with companies at all stages of development.

“The bank is in the business of collecting interest, not foreclosing on collateral,” Stumpf said. “Selling the business or some of the ground that you don’t want to sell can be the only way to survive,” he said.

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This can be a good problem for business owners who have contracts lined up that will create significant cash flow but for which expansion is first needed. But selling equity to fund expansion is often a dreaded decision — and for good reason.

“You don’t want to go the way of angel investors, because you know you’re giving away a whole lot more than you’re getting,” Stumpf said. “In a fast-growing business, you sell 10 percent for cash to make it continue to grow, but when you’re growing 30 percent to 40 percent a year, that’s a heck of a return on capital” being given to someone else. “It’s a shame when that happens with a viable business,” Stumpf added.

Sherman said many entrepreneurs need to turn to the equity markets to solve cash flow problems, reaching out to angels, angel networks, online funding or private placements, especially when they lack real estate or inventory or equipment to pledge as collateral. In the short term it can be attractive, since it does not need to be paid back, but in the medium and long run it can be “a very costly source of capital” for a business that is growing and can expect its equity to increase in value, Sherman said.

One hybrid strategy is to partner with an angel for a bank loan, where the angel provides a guaranty with its personal balance sheet to secure the loan and receives equity or warrants in return. The business owner is still giving up equity, but far less equity than in a straight sale, since the risk to the investor is much lower, Sherman said.

There is an operating principle of entrepreneurship that makes it likely that business founders will face this situation at some point in a company’s development. Owners plow profits back into a business, and the business itself is often 80 percent to 90 percent of their net worth, Stumpf estimated. In a fast-growth business, retained earnings should be low because the owner is reinvesting in the business.

“They will do whatever they can to keep the business alive,” Stumpf said. His prime example is himself. “What I took out of paycheck in the first few years was insignificant. I was buying new computers or subscribing to information services or doing marketing programs. I don’t have a million dollars’ worth of a factory behind me, but I was still doing same thing — reinvesting in the business rather than taking big paychecks home.”

As CEO and co-founder of small-business finance company Biz2Credit, Rohit Arora has a lot of experience with business founders facing the decision to sell as a result of early success. Owners of quickly growing business are barely paying themselves and can only withstand so much of a lack of equity in the business before it becomes a cash flow challenge. “While you’re doing great on paper, just to keep operating at the expanding scale, we have seen owners have to get an equity infusion,” Arora said.

Entrepreneurs can raise money in the debt market, but after a certain point debt gets very expensive. “It’s a classic mousetrap,” Arora said. “A growing business that looks good and there’s lots of money going in and out, plenty of cash flow, but any time there is a hiccup, all the cash flow gets sucked up.”

One of Arora’s clients, an entrepreneur in his 30s who rapidly grew a series of franchised smartphone stories in New York City, borrowed often from the Biz2Credit platform as the business grew to 50 stores over four years. The expansion was so swift that it turned into an asset-rich, cash-poor situation, with the entrepreneur needing more money to run the 50 stores, and for reasons from payroll to stocking expensive smartphones. The notorious Samsung Galaxy Note 7 fire recall put this owner in an immediate cash crunch — he had to wait three to four months for compensation from Samsung.

He really only had two options: Sell a stake or sell the entire operation. He ended up doing both, initially selling a stake but ultimately selling the entire business to a large distributor of phone accessories who was keen to reach customers directly.

“I’ve seen it so many times,” Arora said. “He needed to give up equity, and once he got it, it stabilized the company. But as an entrepreneur, it was difficult working for someone else. He decided it was better to get totally out.”

“In any high-growth business, I don’t think you can do anything much different to avoid it,” Arora said, though he does suggest that geographic expansion beyond an existing successful footprint be considered with caution.

For entrepreneurs, the good news is that there’s always another business to create with the proceeds from a sale. The smartphone store entrepreneur could have sold to a bigger chain or even at a higher price if his hand hadn’t been forced, Arora said. But he made good money and is now back with several new businesses, including one in the smartphone accessories market.

He took what he learned about selling accessories and doing smartphone repairs to the online world, where margins and volume are higher. And instead of lamenting the loss of physical stores, the entrepreneur has eliminated the risk of a cash crunch associated with retail locations.

Via CNBC

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