Source: Krista Tuomi, Associate Professor, American University
Bank loans are appealing to startups who fear loss of control/equity in their venture. And certainly in the early stages of a startup, or for those with a limited expansion plans, these can be an important financing source. However there are a number of factors that need to be taken into consideration with respect to bank loans for startups. First and foremost is the retention of control of the company. There is the widely held belief that a bank loan means no board seats or outside involvement, but it doesn’t take long for a bank loan applicant to learn how onerous bank loan covenants can be. For example, many loans (and all SBA 7(a) backed loans) require a personal guarantee on the part of the entrepreneur when other assets are insufficient to fully collateralize the loan. This often translates into a claim on equity in the entrepreneur’s personal residence or their spouse’s discretionary personal income. Banks may also require a specific debt service coverage ratio and regular certification before businesses can tap their credit lines. Moreover, some banks insert clauses (called confession of judgment clauses) that give them permission in the case of default, to file a judgment against the business and other guarantors, without filing a lawsuit.
Another strong appeal of debt is the interest deduction it engenders, giving it a relative advantage over equity. To deduct and account for this, however, businesses need steady profits. Losses can be carried forward to an extent, but their value diminishes with time. Startups rarely have either steady profits or the luxury of time which are usually the most critical concern of bank loan officers – does the company have the free cash flow needed to service the debt?
A further banking myth is the time required. Loan approval can be lengthy and tedious. Not only do banks often rely on the always contentious FICO credit scores, but FDIC regulations can lead to a bureaucratic application process and long processing times, after which many businesses are still refused. FDIC requires bankers to defer judgment on loan requests until a physical loan application has been presented, a credit report has been obtained at the expense of the bank, and a formal declination can be mailed to the applicant. (FICO’s Small Business Credit Scoring Service is more nuanced and based on more credit indicators than FICO, and some banks are thankfully moving in this direction.)
Many startups are referred to banks through the local economic development authorities. The SBA Loan Guarantee Program has helped some small businesses, but is less useful for fast growing startups. It guarantees 50% of loan amounts of up to $350,000. Putting aside the time required for approval and the paperwork required the SBA program, like most banks, works better for established small businesses with adequate collateral.
In fact, despite the push to expand loans to small business, the refusal rate for loans to start-ups is notable. Post-recession regulations and deleveraging have made banks even more risk averse than before. In the recent Joint Small Business Credit Survey Report conducted by the Federal Reserve Banks of New York, Atlanta, Cleveland and Philadelphia, a majority of small firms (under $1 million in annual revenues) and startups (under 5 years in business) were unable to secure any credit. Lack of credit availability was also the top listed challenge for startups in 2014. The average approval rate for all debt sources (large banks, regional banks, community banks and online lenders) was only 38%. Moreover, 30% claimed that they were paying more to finance the same amount of debt, suggesting a rise in interest rates or other fees.
This sentiment was echoed by the former SBA chief, Karen Mills, when she noted that commercial loans of less than a million dollars are down about 20% from pre-recession years, even as total commercial lending has grown. She also holds that the new regulations requiring larger capital reserves “undermines (banks) ability to underwrite small-business loans.”
More research will be necessary to determine the cumulative effect of bank tightening on startups, as it possible that alternative finance options (P2P lending, angels) can fill some of the gap. In the meantime startups should be made aware both of the risks involved with bank loans, as well as the financial shape they need to be in in order to get one.
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