Thursday, June 16, 2011

Lesson #49: How to Get a Loan, or Not!!

I am chuckling to myself while typing this post, as the concept of startups getting traditional loans is the equivalent of first-timers trying to summit Mount Everest; it is nearly impossible for a true startup to have any realistic chance of closing a traditional loan with a bank, or elsewhere.  So, for all of you really early-stage entrepreneurs out there, your time will be better spent elsewhere, as it is very unlikely you will ever get through a bank's underwriting process and meet their very restrictive criteria (detailed below). 

If this describes you, and you prefer to raise debt instead of equity, it is most likely going to come in the form of a convertible debt instrument from a traditional angel investor, not a bank.  So, go back and read Lesson #5 on How to Find Angel Investors, and pitch those angels a debt instrument, instead of equity, and you will most likely negotiate towards some convertible debt instrument in the middle.  That said, if you are beyond seed stage, and are actually driving profits that can service a loan, keep reading.

Notice I said "driving profits", as without profits, the loan conversation is practically a non-starter from traditional sources.  And, frankly, in the current economic climate, the traditional banks are ultra-conservative, not looking at any company without at least $3MM in annual profit, and a proven multi-year historical track record at such level to boot.  Perhaps you can find a more aggressive bank, like Silicon Valley Bank that specializes in earlier stage businesses, which may be a little less restrictive.  But, they too will require meaningful profits to ensure you can cover the debt service costs and the ultimate repayment of the principal within the term.

In addition to a proven multi-year history of company profits based on your tax returns, a lender is most likely going to want to see: (i) enough hard-assets in the business to collateralize the loan; (ii) a personal guarantee from you, so you are personally on the hook if the company goes under; (iii) sufficient equity invested in the business as a percentage of total capitalization; (iv) a credible business plan and financial forecast that shows a timely repayment of the loan; and (v) a good credit score for you personally.  So, if you don't have any of these things, or are unwilling to provide them, that pretty much ends the bank discussion, and it is back to the angel investors or venture capitalists for you.

Now, there are a few exceptions to the rule.  If you are trying to finance hard assets (e.g., equipment, real estate), or bridge known accounts receivable for working capital purposes, certain lenders or factoring companies could be a little easier to work with, lending 50%-80% of the asset value depending on the nature of the assets and risks associated with loan recovery.  This includes financing any equipment or other physical assets through capitalized leases, which require minimal upfront payment for the assets, but over the life of the lease, typically add up to 2x-3x the cost of the assets had you purchased them for cash upfront.  Just how mortgage payments add up on your house over time (therefore helping near term cash, but hurting long term cash).  These asset-backed lenders will also require personal guarantees, which are never fun if your business goes under, as it can take you down personally, as well (adding insult to injury).

And, if you are financing real estate, there are plenty of mortgage companies to reach out to.  But, you will need to have enough personal or other income to insure that the mortgage costs (combined with the costs of any other debts you have, like your home mortgage or car loans) are not higher than 40%-45% of your monthly income.  Not to mention, having enough other cash on hand to afford the 10-20% down payment.  I don't know many startups or entrepreneurs that will successfully meet this criteria, so most likely, this too will lead to a dead end.

One additional road to consider is trying to apply for an SBA-gauranteed loan.  In this case, the SBA is not the lender, the banks are still the lender to approach.  But, the SBA guarantees up to $200,000 of the loan,  hence making the loan a lot less risky to the bank.  So, a bank's lending criteria is a little more lenient for loans under this amount, assuming the SBA guarantee is in place.  And, the terms of the SBA-guaranteed loan, tend to be a lot longer, given you more time to repay the loan.  To see if you meet the criteria for an SBA-guaranteed loan, check out this link on the SBA Website.  But, keep in mind, you will have to have 10%-30% of additional cash sitting around, to contribute as additional equity, to close a loan like this.  So, in this case, once again, it takes money, to raise money (monies you most likely do not have sitting around).  And, the SBA will only provide a guarantee, if you really have run out of all other options (e.g,. no excess cash sitting around, and have been turned down by a bank already).

Sorry to be "doom and gloom" in this post, as that is not my style or desire, to demotivate entrepreneurs.  But, just keeping it real, to save you from wasting your valuable time.  I have personally approached enough banks enough times in my past, in better economic markets than these and with more sizeable businesses than your own, to know how really tough it can be to get through the underwriting process.  So, my advice to most of you looking for loans for your startups:  focus on angels, venture capitalists or other alternative asset-backed lending sources, not the banks, which will most likely lead to a dead-end for startups.

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