debt stacking

How Debt Stacking Can Threaten Your Business

Debt stacking can destroy your business, yet many entrepreneurs are unfamiliar with the term. Debt stacking is when a business takes out multiple, overlapping loans and/or merchant cash advances without paying off earlier loans, and the debt stacks up.

The result is a business saddled with an exploding amount of debt, in which the debt service costs (or payment of interest charges and repayment of principal) make increasing demands on the company’s cash flow. The outcome is insolvency followed by bankruptcy.

Related: Demystifying Small Business Debt to Unlock Growth

How debt stacking damages your startup

When a business takes on debt, it agrees to repay the debt with interest, referred to as debt service. The loan is normally repaid in monthly installments with interest added on, but some lenders offer weekly or daily repayments.

Debt service requires cash, which must come from operations, equity (the company’s retained earnings and capital contributions) or further debt. A business might decide, for instance, to take out a loan and repay it with cash from sales. However, if the cash falls short, it will have to turn to cash in the bank, the owner’s private cash, or another loan.

While some startups borrow from banks, the tendency in the last few years has been to borrow from online alternate lenders that promise loan proceeds in days rather than the weeks normally required by banks.

Owners who decide to take out additional loans have two basic choices:

  1. Consolidation: Take out a larger loan and use some of the proceeds to pay off earlier loans. This is the less risky way to borrow money and makes sense if your company is growing. However, if you continue this process for too long, the amount you owe could become ruinous.
  2. Stacking: Take out additional loans without repaying the older ones. Each loan adds to your total debt service costs and soaks up more of your cash. You risk running out of cash, missing debt service payments, and being sued by your creditors. The usual outcome is bankruptcy, when lenders take possession of the company’s assets, plus any personal assets pledged by the owners, and sells them for cash that is used to repay the loans.

How can debt stacking occur?

Most lenders avoid participating in debt stacking, but there are several information weaknesses in the lending industry, particularly the online sector. Online lenders usually promise loans in one to three days. The paperwork to record existing loans takes longer, meaning that a borrower could load up on several loans within a short time without tipping off the lenders that multiple loans were being stacked. Often, the same collateral is simultaneously pledged to multiple lenders.

Some providers of merchant cash advances (MCAs) use loan information filed with a state’s government to seek out and offer stacked debt to businesses. In this scenario:

  1. A company takes an online loan, pledges collateral and signs a lien over to the lender for the collateral. The lien allows the lender to sue and take possession of the collateral.
  2. The lien on the collateral is filed via a UCC-1 statement with the state’s secretary of state. The first lien filed on specified collateral has first rights to acquire and sell it in case of default. Holders of secondary liens on the same collateral are serviced in the order they file UCC-1 statements.
  3. An MCA provider checks for new UCC-1 filings and contacts the borrower to see if they want additional loans. These will be stacked atop the existing loan. The MCA provider takes a lien on futures sales revenues earned by the borrower rather than the conventional collateral other lenders require.

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How to work out of a debt stack

If your business owns a stack of debt that it can’t repay and you default on your loans, lenders may sue in bankruptcy court to enforce liens on pledged collateral. If the collateral consists of real property that has been pledged to multiple different lenders, the first lien holder is likely to collect any money, because the collateral is frequently insufficient to repay the whole loan, much less any of the secondary lien holders. Nonetheless, the first lien holder will likely take what it can, leaving other lien holders high and dry.

However, consider the case in which your business has stacked multiple MCAs collateralized by future revenues rather than hard assets. The first lien holder doesn’t benefit from your bankruptcy. Instead, you and the lien holder share a common interest in keeping your business afloat so that it can collect its share of future revenues. Therefore, the first lien holder is likely to work out a plan with you to repay the MCA on more favorable terms. The same pressures will motivate secondary lien holders to follow suit. If you can work out a repayment plan that is supported by your cash flow, you might be able to keep your business intact.

Debt stacking is a highly risky strategy that can lead you to take on unaffordable debt levels. In some situations, you might be able to work out a recovery plan with the consent of your creditors, but debt stacking often leads to insolvency and bankruptcy. Consider hiring a workout consultancy to help you recover from debt stacking.

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