Debt Consolidation vs. Debt Workout
When faced with unsupportable debt, small business owners look anywhere possible to obtain relief and save their business from financial disaster. They scour the internet for answers or speak with trusted advisors and most frequently get one of two answers: either pursue a debt consolidation or pursue a debt workout. Often these terms are used interchangeably, but they mean very different things. Both options can be useful tools, however, they can also be very dangerous if you do not understand the nature and implications of each strategy. Far too often we see struggling people preemptively signing up for the wrong service for the wrong reasons, ultimately doing more harm than good. While there are many interpretations of what a debt consolidation or a debt workout is, listed below are the key points of each.
Debt consolidation is essentially a refinance: consolidate your multiple loans into one new loan. By combining your multiple debt service payments into one lower payment, the business will experience cash flow relief but no actual principal debt reduction. The result is that more money will be paid over the life of the loan, but less money will be paid each month.
Debt consolidation is not always a simple refinancing, however. In most cases, consolidation loans require that businesses qualify for enough to both pay off their existing debts and put as much as 50% of the new loan into the business as working capital. For example, if a business had $50,000 worth of debt from three loans that they are looking to consolidate, they would need to qualify for a consolidation loan totaling $100,000 so that $50,000 would pay off the old debt and $50,000 would go into the business adding liquidity to the balance sheet. If the business cannot qualify for a $100,000 consolidation loan, it will likely not be approved at all.
A successful consolidation can turn a struggling business around, however the qualification requirements mentioned above are often not clearly described to the applicants. Therefore small business owners who are already over-leveraged will waste time and money getting rejected by one consolidation program after the other. Instead of taking steps to resolve their debts through other more plausible and efficient means, the business owner is frequently left with no money and no time to resolve the dire financial issues at hand.
Paying a Third-Party Company
The other main use of the term “debt consolidation” refers to programs whereby you start paying a third-party company a reduced amount each month and stop paying your creditors directly. The third-party company negotiates reduced monthly payments with each of the creditors hoping for cooperation from all of them to achieve a global resolution. Similar to the consolidation loan, this plan is not targeted at debt reduction but at achieving a lower monthly payment. The business owner may pay increased interest or penalties for not paying as initially agreed on its contracts, but if successful, will avoid litigation and long-standing default with their creditors.
The risks associated with this type of consolidation are that business owners with multiple creditors face a high likelihood that not all their creditors will agree to the reduced payment terms offered by the third-party consolidation company. This would eliminate the ultimate goal of a global resolution. In that instance, the business owner may still face the threat of a lawsuit, collections efforts, or liquidation from one or more of their creditors which is exactly what he or she was trying to avoid when hiring the third-party company in the first place. This results in no debt reduction on the creditors who do agree, increased fees and interest owed by the business across all debts, and despite the business owner’s best efforts, they may ultimately be faced with litigation and closure of their business.
Debt workouts can refer to a variety of things. It can mean renegotiating the terms and conditions of a debt, often called a loan modification, but the primary debt workout strategy is obtaining a settlement of the debt for less than the face value amount owed. The goal of a debt workout is to remove the debt service payments and to obtain debt forgiveness.
When done properly, a debt workout company (or a “DWC”) will work with the distressed business to make sure that it and its guarantors are protected from typical debt collections efforts. After placing the distressed company in the best position possible for a settlement, the DWC then reaches out to the creditors and negotiates a reduced payoff. The amount of debt reduced will be dependent on a number of factors, which include the type of debt, the amount of the debt owed, the value of business assets, and the value of personal assets (where applicable). When a settlement agreement is signed and paid, the business, the guarantors and any liens in place on business or personal assets are released. The business is free to move forward without its debt and further threat of collection efforts from creditors.
When faced with unsupportable debt, a business owner needs to choose a path that gives them the relief they truly need. If pursuing a consolidation, ask the third-party company what their process is. Are they issuing a new loan to consolidate your debts? If so, what are the qualification requirements? Are they taking money from the business each month and negotiating new payment terms with each of the creditors? If so, what happens if all creditors don’t agree?
If interested in pursuing a debt workout, we encourage that you call our office and request a consultation. There is no one-size-fits-all approach to a debt workout, and it is best for you to get an explanation of what the process will look like based on your circumstances. Click here to request a consultation.