If your experience with startup businesses is mostly based on what you’ve seen in movies, you may think that small business financing is as easy as walking into a bank and having a quick meeting with the manager. If you have a startup, you just need to put a business plan together first.
In reality, banks are reluctant to make new business loans. Increasing credit standards and harsher regulations have made it harder for banks to make loans to risky businesses. Read on to learn how you may pull off a bank loan and what your other options are.
Is a loan the best option to fund your startup?
The best benefit of using a loan for business startup funding is that you don’t have to give up equity, as you must with venture capital (VC) or an angel investor. Any investment in your business comes at a steep cost, whether it’s equity with venture capital or high interest rates that often come with startup loans. And both can be difficult to come by.
When a loan makes sense for your startup
The best time to seek a loan is when the startup is the next step of your career. If you’ve built up experience as an executive or manager in an existing business and are ready to step out on your own, debt financing could work for you.
On the rare occasion that banks make startup loans, they only do it for people with plenty of management experience. This means you know the industry, know how to make and stick to a budget, and know how to handle employee relations.
Sticking to a budget is key. Loan payments are a big fixed expense to start a business with. You have to have experience making ends meet. And, former executives out to start their own business have often spent years analyzing how their employer does things and have made their own plan to improve upon that strategy.
When you should seek other funding sources
If you just came up with the next great infomercial product or social network, don’t waste time thinking about getting a loan. At this point, it’s likely you wouldn’t even qualify for vendor financing.
If you don’t have prior industry and management experience, startup businesses are full of unproven factors. The product, the business model, the management team, are all unproven. Each factor is an additional risk for a lender.
Where can you find a loan for your startup?
If you think your business could qualify for debt financing, here’s where to look.
1. Friends and family
Always start with friends and family. They will likely be the most open to lending to you and most trusting, and the interest rates they charge (or don’t charge) will likely be lower than what you could get at a bank. Just remember, you may be risking a long-term relationship. Money can make people act strangely.
2. The SBA
When banks extend loans to start a business, they lend with a guaranty from the Small Business Administration (SBA). The SBA guaranty protects the bank from the risk of default.
SBA loans for startups have many requirements. You have to prove you have sufficient management experience. Your FICO should be at least 680. You have to put together two years of financial projections that show the ability to make monthly loan payments by year two, and you have to have solid backup for your numbers.
To put the difficulty of getting a bank loan, even with an SBA guaranty, for a startup business in context, when I worked as a business loan officer, I worked on somewhere between twenty and thirty startup loans over two years. Only three were funded.
3. Venture debt
Venture debt is the way venture capitalists finance fast-growing startups with debt, which is typically convertible into equity. This avenue is only available to businesses that have the potential to grow into the hundreds of millions of dollars range. Don’t worry about it if your business won’t quite get there — venture debt is the most expensive of these options by far.
3 advantages of getting a loan for your startup
Here’s the case for getting a loan.
1. Retain equity
Equity is a big deal. The business was your idea, you run it, and you take big risks, so you should own as much of it as possible. If you give up 20% of your company now, as you likely will with venture capital, you’ll live to regret it.
2. Work on your plan
Raising capital through debt or equity instead of using your own funds forces you to pitch your business to third parties. We all have our own biases, and taking the time to think through various concepts you’ve come to accept as impenetrable in your head can help you to make your business the best it can be.
3. Keep control
When you raise money by giving away equity, you invite your investors to demand some oversight or even control over the business. They may want to have a seat on the board of directors or go as far as have signing authority over big purchases.
When you get a loan, you commit to various covenants in the loan agreement, but you decide how your business is run.
3 disadvantages of getting a loan for your startup
Here is the case against getting a loan.
1. Increase break-even point
By committing to a loan payment, you make it that much harder to have positive net income and cash flow. It can be a good thing if it disciplines you to not hold out for the perfect job or customer, but it makes it more difficult to meet payroll and other expenses.
2. Risk personal assets
Startup businesses don’t have collateral for a loan. The bank will want it from somewhere, and most of the time, that means your house. If you default on the loan, the bank will repossess your house and sell it to pay the loan down.
I had a colleague who was at the signing table ready to fund a startup loan perfect in every other way, but the owner had not told their spouse they would be putting a second lien on the house. The deal fell through.
Pro tip: if you’re cool with putting your house at risk, get a home equity line of credit before you apply for the business loan. It will be a lower rate, and the SBA doesn’t require the bank to take a second lien if the equity balance in the house is less than 25% of the home value.
3. Loan covenants
Covenants aren’t quite as onerous as giving over control of your business, but they could still stuff a banana in your tailpipe if you’re not careful. The most common is for banks to require you to provide quarterly financials that are relatively in line with what you projected during underwriting.
Startup businesses sometimes hit speed bumps, and you don’t want the bank on your back threatening to call the loan if you’re struggling to make the business work. Sometimes it’s better to have the space to make it work before you have buyers.
Best practices when applying for startup loans
Keep these items in mind when you apply for loans.
Have the paperwork done
To get a business loan, you need to actually have a business entity. This means filing with the state, getting a tax ID, creating and filing articles of incorporation, and deciding how the business will be taxed.
If you apply for a loan and none of this is done, the loan officer may think you’re wasting their time and won’t spend much time working with you.
Be ready with answers
There’s a well-known financial acronym, CYA, which means cover your, uh (insert word for tuchus). As I have mentioned once or twice in this article, startup loans are risky. The bank will be doing CYA as much as it can so if the loan defaults, it can show it did due diligence.
This means you’ll get a ton of questions about your experience, your future clients, who will work for you, and how you came up with your projections.
Don’t BS your projections
You may be the perfect person to start this business. You have just the right focus and experience to get the job done, but there’s no way for the bank to know that. The underwriter has to show the business will work financially.
They will compare your projected financials to industry averages and scrutinize the assumptions you made to come up with the numbers. If you spend five minutes on the projections, they’ll know, and you’ll likely have to redo them with some effort.
Getting started
The most important thing is getting your business started. The internet is full of wantrepreneurs always daydreaming about their future business and never starting it. If it takes a high-interest loan to make the full sale, that might be better than never making a sale.
The post Should You Get a Loan to Fund Your Startup? appeared first on The blueprint and is written by Mike Price
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