Debt restructuring vs refinancing: what's right for your business?

Refinancing replaces your debt with new debt on better terms, and it works while lenders still want your business. Restructuring changes the terms of debt you can no longer pay as agreed, and it usually costs more. If you can refinance, it is usually the simpler path.

Debt restructuring vs refinancing becomes a real question when you are behind on payments, or close to it, and the lender has gone quiet or nervous. Someone says "restructure or refinance," and the two words sound alike. They solve different problems, and picking the wrong one costs time you may not have.

Debt restructuring vs refinancing: what is the difference?

How do you tell which one you need?

Answer three questions about the last 12 months. Are you current on every payment? Does your cash flow cover today's payments with room to spare? Would a new lender look at your statements and say yes?

Three yeses point to refinancing. A no on any of them points to a restructuring conversation, and a missed payment or a covenant breach means the conversation should happen now, before the lender decides for you. At that point, gather your loan documents and a current cash forecast before you call the lender.

When is refinancing worth it?

Refinancing is worth a look when your rate no longer reflects the business you have built, when payments crowd out hiring and working capital, or when better loan products exist than the one you took. The U.S. Small Business Administration lists refinancing current business debt among the permitted uses of a 7(a) loan, which is capped at $5 million.

Test the numbers before you commit, including every fee. For example, suppose you owe $500,000 at 9% with 60 months left, a lender offers 6.5% over 60 months, and the fees and a prepayment penalty total $13,000:

The refinance saves about $596 a month, so it pays back the $13,000 in roughly 22 months and saves about $22,800 over the full term. If you plan to sell the business or pay the loan off within 18 months, it does not pay at all. The numbers are an example.

Hold off, too, if your results have slipped in the last few quarters. Lenders price the recent past, so a refinance now can come with worse terms than the loan you have. Stabilize first, then ask.

What do lenders look at before they approve a refinance?

• Debt service coverage: whether your operating cash flow covers the new payments, with room to spare.
• Time in business and revenue trend, where steady results count for more than one strong year.
• Credit profile, business and personal, depending on how the loan is structured.
• Collateral and existing liens, because assets that are already pledged limit your options.

Ask each lender what minimum coverage it requires and how it calculates it, since the definitions vary.

How much debt can your business carry?

Four ratios answer it. Lenders use variations of them, so treat these as a self-check and not a lender's formula.

For example, a business with $400,000 of EBITDA, $1.2 million of debt, and $300,000 of yearly loan payments has debt to EBITDA of 3.0 and, using EBITDA as the cash flow, debt service coverage of about 1.33. If a new loan would push that coverage toward 1, a lender will see little room for a bad quarter, and so should you.

What does a restructuring involve, and what does it cost?

A restructuring can stretch the term, lower the rate, add an interest-only period, waive a covenant, convert part of the debt to equity, or forgive part of it. The lender may ask for something in return, such as a higher cost later, a stake in the business, or closer reporting.

Two points need care before you agree to anything. According to the Internal Revenue Service, debt that a lender forgives is generally taxable income to the business unless an exclusion applies, such as bankruptcy or insolvency, so work out the tax cost of any forgiveness before you accept it. Converting debt to equity changes who owns and votes in the business, so read exactly who gains ownership and votes under the terms before you agree.

Going into the conversation, bring facts:

1. A list of every debt: lender, balance, rate, monthly payment, maturity, collateral, and anything you have pledged personally.
2. A 13-week cash forecast that shows what you can pay and when.
3. A proposal: the payment you can make, for how long, and what changes if results improve.

Present it early, and model what the new terms do to your cash before you sign.

What to do next

1. List every debt with its rate, payment, maturity, collateral, and any personal pledge.
2. Build the 13-week cash forecast, and work out your debt service coverage for the last 12 months.
3. Answer the three questions above to see which situation you are in.
4. If it is refinancing, get quotes from at least two lenders and model the break-even with every fee and penalty. If it is a restructuring, work out the tax cost of forgiveness and who gains ownership under any equity conversion before you talk about either.

To prepare the numbers a lender will ask for, see how Surfside Capital Advisors helps owners with cash flow and working capital planning. The article on how to improve cash flow for your business covers the levers that ease payments before you borrow. The article on financing options for small businesses compares the products you may be offered.

Questions owners ask

Is a restructuring the same as bankruptcy?

No. A restructuring can be an agreement between you and your lender without a court. Bankruptcy is a separate legal process, and whether it belongs on your list is a legal question this article does not answer.

Can you combine several loans into one?

Yes, and that is a refinancing: one new loan pays off several. It simplifies payments, but compare the total cost and not only the payment. On $200,000 at 8%, a 60-month term has a payment of about $4,055 against $6,267 over 36 months, but it costs about $43,300 in interest against $25,600.