Startup businesses can get financing from a variety of lenders, but bank loans are typically off the table for businesses with very little revenue and time in business. Banks shoulder some level of risk when they lend funds to any business, but startups are especially vulnerable to defaulting on loan payments because they’re still putting down their roots.
Building a company from the ground up is part of what makes startups so exciting though, and alternative forms of funding can help bring entrepreneurs’ visions to fruition. Rather than consulting banks, startup businesses may be better off exploring business credit cards, microloans, online loans and personal loans.
Reasons banks don’t finance startup businesses: Unlike established businesses, startups haven’t had a chance to prove they can reliably bring in enough money to make their loan payments. Here are some reasons startups don’t meet the criteria for most bank loans; They don’t meet minimum time in business requirements- Banks commonly stipulate that businesses need to have been operational for at least two or three years to qualify for a loan. Having that experience under their belts boosts the likelihood that they have an established customer base and a viable business model. In turn, they’re considered more trustworthy and capable of making their loan payments.
They haven’t built business credit history yet-If a business is just gaining its footing, chances are its business credit history is short or nonexistent. Banks generally look for business credit scores of at least 650. Startup owners can build up their business credit by getting an employer identification number from the Internal Revenue Service, setting up trade lines with suppliers, opening a business credit card and making payments on time. Their annual revenue isn’t high enough-Businesses don’t always become profitable immediately after opening their doors — in fact, it can take years. Banks usually like to see that businesses have annual revenue of at least $100,000 to $250,000. The more consistently they’ve met those annual revenue requirements, the better. Most startups are likely still working toward this goal.
Their cash flow isn’t reliable-It takes time to find out which products or services sell best, hire the right employees and successfully reach a target audience. All of these factors can impact cash flow, which may not be very steady during a company’s early stages. Established businesses have the advantage of being able to present banks with years of profit and loss reports and cash flow statements. Startups often don’t have such a collection of financial statements yet.
How can banks deal with their high credit risk to the startup loans: Entrepreneurship seems to have become more accessible: open source technologies and cloud storage solutions are reducing the cost of software development, remote working is gaining in popularity and eliminating office costs, yet, funding remains the main obstacle to the development of a startup. Self-funding is the main source for startups, followed by business angels and venture capital funds. Banks are absent from this podium, as they are often reluctant to offer startup loans due to their high credit risk. Financing, a critical issue for startups. Very few startups escape the rule: high levels of capital are required to develop innovative products and solutions. It often takes several months or even years of R&D before a marketable product is developed.
Thus, during its first years of existence, a startup will spend a lot of money to pay for its premises, recruit qualified employees, develop prototypes, without generating any turnover. When they are founded, startups are often supported by organizations and structures promoting the financing of young entrepreneurs, under the impulse of government initiatives. But between two and three years of existence, new challenges arise. Scaling startups face serious financing problems even though they need it to finalize their product or accelerate their commercial development. Indeed, even if it generates revenues, a startup needs funds to enable rapid growth.
It is only a few years later that it can hope to reach profitability and finance its own development. To meet this need, many startups turn to venture capital funds or business angels. These players are used to taking risks and are aware of the particularities of startups, unlike traditional banks.
Banks are static cagey to offer startup loans: The mitigation of credit risk is at the heart of a banker’s job. The bank must ensure that any borrower, whether an individual or a company, will be able to repay the loan on the due dates set out in the contract. Credit risk analysis is essentially based on financial data, in the case of a company, the bank will study the company’s revenue, level of indebtedness, cash flow, etc. Unfortunately, this approach is ill-suited to startups.
As mentioned earlier, a startup needs a lot of capital to develop and it can take time to generate revenue. An early stage startup will have very little financial data to present to a bank. Moreover, at the R&D stage, it is not always clear whether the startup will be able to find clients or whether its product will be suitable for the market. Indeed, it is estimated that 90% of startups fail and only few of them manage to reach profitability.
In addition to this high risk, startups often lack guarantees to provide to banks. Many entrepreneurs are recent graduates or young professionals who cannot provide personal guarantees. Startups do not necessarily have physical assets to offer as collateral since nowadays many products are digital i.e. SaaS, mobile applications etc. faced with this reticence on the part of retail banks, public banks have put in place numerous funding programs, which were reinforced during different crisis. Hope, governments would like motivate private banks to take over by providing more loans.
Reasons for encouraging bank loans: On the startup side, loans help to limit the dilution of their capital. Founders and initial shareholders can retain control over their management by opting for non-dilutive funding. Loans can also be used as a bridge between two rounds of fundraising, enabling the negotiation of a higher valuation. There is also venture debt, which is halfway between debt and equity financing. It can be interesting for banks to bypass credit risk and add high-potential startups to their client portfolio. Indeed, startups make up the market of the future and represent a strong potential in the long term.
They might become important mid to large-sized companies with multiple banking needs, account management, international development, export by granting them a loan, banks can thus set the foundations for a fruitful and lasting customer relationship. Besides financing, banks can support the development of startups by offering advisory services, as some multinational banks do throughout the crisis period. They can also provide growth opportunities by connecting their business clients to their network of partners and suppliers. So, it seems essential for banks to improve their relationship with small businesses.
Better assess the credit risk of a startup: The main obstacle to this collaboration seems to be the high credit risk of startups. The challenge is to better assess this risk, taking into account the specificities of these young innovative companies. As mentioned, relying solely on financial data does not allow for a proper assessment of a startup’s growth potential. Financial data is usually insufficient, sometimes non-existent at the beginning of the project, but above all, it can paint a misleading picture of the company. However, investors were disappointed once internal dysfunctions were revealed and the valuation fell to the exact volume.
The IPO then fell through and the company suffered a series of setbacks. To assist commercial banks and debt funds in assessing startup credit risk, Early Metrics scores financial and non-financial criteria it may observe at the governance of the startup, including the composition of the management team, its involvement and complementarity. In parallel, it may assess the business model, the innovation of the product, and the dynamics of the target market.
These criteria, refined and weighted thanks to back testing studies, allow us to estimate the potential of a startup. Back testing consists of tracking the survival and/or success of startups in database 12, 24 and 36 months after the rating, the process allows to create a reliable predictive model of the survival rate according to the sector and the stage of maturity of a startup. These analyses, therefore, provide banking players with a more comprehensive view of the risk profile of innovative startups.
Financial institutions and banks should not miss out on tomorrow’s market leaders: Rather than seeing high credit risk as an insuperable hurdle, banks should learn to better assess the growth potential so as not to miss out on future tech stars. Knowledge is the first step towards better risk management. Banks and debt funds should therefore improve their knowledge of startup-related topics. Needed in-depth analyses, these debt players will be able to make informed loan decisions and contribute to the development of young companies that are driving the economy of tomorrow.
