The market for startup loans is growing rapidly, and a growing number of startups are adding this form of funding to their financing mix. The growing demand comes as no surprise; startup loans are by virtually all measures the cheapest form of financing a startup can obtain. In addition, the non-dilutive element is quite attractive for founders and early-stage investors alike. Thus, understanding the dynamics of non-dilutive financing is becoming a high priority for founders and CFO’s alike.
In the first of two blogs, I aim to shed light on the underlying theory behind startup loans. Understanding the theory and dynamics will significantly improve your odds of obtaining a loan. In the following article, I will present practical tips and tricks on the when and how of obtaining a loan. Also, to be clear: by startup loans, I am referring to bank loans tailored for startup companies. Revenue-based financing and pure Venture Debt are different by design, but the same theory and logic apply to all forms of non-dilutive financing.
Understanding the lender
The conventional wisdom is that startups and debt do not mix. Startups without track records, positive cash flow, or tangible assets/collateral have typically been a big no-go for banks due to the uncertainty of loan repayment. Lenders typically rely on historical figures to assess the borrower’s creditworthiness, which makes perfect sense; wouldn’t you also instead lend money to someone who has already proven that they can execute on whatever they said they would?
But why are lenders so risk-averse? Simply put, lenders have the same downside risk as VCs but a limited upside. Lenders count on having their loans repaid with interest, preferably without defaults. On the other hand, VCs can afford to have a large number of investments fail because of the oversized returns they receive from a handful of investments. An equity investment can ideally generate 10X returns, whereas a similar loan will yield relatively little interest payments. In addition, multiple loans aggregate interest payments are required to cover the losses should a single loan not be repaid. This dynamic explains why lenders have a cautious approach. Moreover, banks are subject to regulation, which underscores the need to exercise caution.
Sure, someone could argue that lenders and banks, in particular, should not examine a loan in isolation but rather from a customer’s lifetime value point of view. It’s a feasible argument to make that lenders should take more risk because a growing customer (relationship) yields higher income in the long run. This is somewhat true, but even when accounting for ancillary income and the growing income of a growing customer relationship, the income lenders earn on successful startups is nowhere near the returns of equity investors.
Does this mean banks do not grant loans to startups? Nope, not at all. You will obtain a loan if you fulfill the prerequisite of the three C’s of Startups Loans, as I like to call it.
Introducing the 3 C’s of startup loans – Cashflow, Cash & Collateral
Cashflow, Cash, and Collateral are the variables that determine whether or not you will obtain a startup loan. Cash flow is the means of loan repayment, cash is the margin of error related to the cash flow forecasts and lastly, collateral is the security for the lender if things go sour.
Cash flow is the first and most important point of departure when assessing the creditworthiness of a startup. A loan needs to be repaid, usually as a fixed annuity, and to do so a company needs cash flow. Sure, a company could pay off the debt using VC investments (cash), but this goes against the principles and purpose of why the equity was raised in the first place. The logic here is clear: the more robust the cash flow, the better the odds of obtaining a loan. In addition, the cash flows should preferably be operational (i.e. not related to one-off grants/subsidies or similar “non-core events”) and somewhat predictable.
Now, there is still the issue of profitability. Cash flow does not matter unless it is positive – or does it? The answer is yes and no, and this is where it becomes interesting. A lender prefers companies with a positive cash flow because it lowers the risk of default. However, in the startup segment, this requirement is not only harsh, but it’s also unrealistic. The vast majority of startups – in practically all development stages – are cash flow negative, meaning that they burn more cash than they receive from sales at any given period. Yet, negative cash flow does not need to be a problem – it’s only a problem when it derives from an unsustainable business model. In other words, an adept lender will understand that negative cash flow is an inherent “virtue” of startups and it’s not automatically synonymous with risk and default. This dynamic is particularly evident in SaaS businesses. Most SaaS businesses are cash flow negative due to the front-heavy cost structure of the business models, in this context, the CAC/LTV ratio. In practice, the more successful a SaaS business is at growing, the worse the business will look from a traditional P&L point of view, as seemingly, yet very real, losses mount up. Thus, understanding the business fundamentals is critical, be it SaaS metrics or something else. Luckily, some banks are learning to re-evaluate the perceived and true risk of startups. We for example feel more comfortable assessing companies’ creditworthiness based on key metrics and forecasts rather than historical figures.
Still, even if the negative cash flow is profitable (yes, I did say that), eventually, the cash will run out. This is why the company’s cash position is so critical. By combining the forecasted cash flows (revenue) with the burn rate and cash reserves, we can understand the company’s repayment ability or simply put the runway in various scenarios. We typically stress test the forecasts with various assumptions, e.g. lower sales or higher than expected burn rate. Stress testing contributes to our understanding of the margin of error we as lenders have. Ultimately, a lender should confirm that the company’s combined cash flow/cash is sufficient to cover the debt repayment with interest and preferably within a manageable margin of error. Accordingly, cash reserves are instrumental in the credit assessment and it shouldn’t come as a surprise that most startup loans are granted in conjunction with investment rounds.
Lastly, we have the collateral one of the significant obstacles for startup loans has been the absence of tangible and of-real-value assets. For example, in a default scenario, the bank cannot sell a startup’s source code or other IPR. Luckily, this issue is solved by domestic and European guarantee products. What it means in essence is that a domestic or e.g. a European guarantee facility covers some of the exposure in a default event. For that reason, it’s practically impossible to obtain a startup loan without leveraging guarantee products, so be sure to check the availability of such products in your country and with your bank.
Improve your chances of obtaining a startup loan
The first step to being successful in human interaction is understanding the counterpart and their motives. And as a startup founder, funding is one of the most critical puzzles you must solve. While this article is non-exhaustive by design, the fundamental logic – when applied correctly – will improve your chances of obtaining a startup loan. In theory, obtaining a startup loan is relatively easy. You only need to convince the lender that your cash flows combined with your current liquidity are sufficient to cover the installments and the interest with an acceptable margin of safety and that there is some sort of guarantee covering potential losses for the lender.
In the next chapter of the Startup loan 101 series, we will learn how to apply the theory and leanings from this article with the practical steps you need to take to make a startup loan a reality for your company!