Hopefully our first six funding fit tips have given you a clearer sense of the kind of preparation and time commitment required for raising capital. In our previous posts, we talked about firming up your elevator pitch, turning a great idea into a product, the importance of nailing your product/market fit, knowing how much to raise, and the power of referrals.
But you may be scratching your head wondering why we’ve focused so much on the complicated and time-consuming process of finding investors. Can’t you just walk into your neighborhood bank and get a small business loan? For early-stage companies, particularly in the technology sector, getting a small business loan from a traditional bank is actually more difficult than you may think. This is especially true since the financial crisis in 2009, after which lending laws got much tighter.
In addition to new, stricter lending standards, banks and VCs operate at opposite ends of the spectrum when it comes to expectations for risks and returns. Equity investors invest in the upside, hoping that their financial gamble on a start-up will have a big payoff someday. By contrast, banks are all about downside protection; they look for steady, on-time payments and a way to recoup their losses if your business fails.
If you’re leading an early-stage technology company, here are four key things you need to know about borrowing from a traditional bank.
1. Bank loans are challenging for technology companies to get
The biggest problem that technology companies face when trying to secure a bank loan is the lack of substantial hard assets. In an earlier post we talked about why banks hate lending to tech companies. Unlike traditional businesses, technology companies don’t have inventory or hard assets that banks can use to offset their losses if your company’s in trouble. This means that a traditional bank will require a personal guarantee instead—your house, your car, your personal bank account, your retirement savings. Not only are you putting your own personal financial well-being on the line, your loan potential is also limited by the value of your assets.
Unfortunately, tech banks—like Silicon Valley Bank and Square 1 Bank—aren’t an option for most emerging companies. Even though tech banks specialize in technology start-ups, qualifying for a loan usually requires at least $5 million in annual revenue or substantial cash on hand from a VC investment.
2. Bank loans have a lot of financial covenants
Banks place tight debt covenants on loans to be sure certain financial ratios and requirements are met. For example, they may require a certain ratio for rolling income levels or how much debt you take on compared to your revenues. And they don’t want your business to be in the red for too long. If you fall behind, the bank can cut off your line of credit or, even worse, make you immediately repay what you’ve already borrowed so far, posing a huge risk to the future of your company.
3. Bank loans aren’t intended to fund growth.
As mentioned earlier, banks will only lend as much as you’re currently worth, which makes it extremely difficult to grow with the funds they provide. Typically, they only offer you a line of credit for your short-term cash needs, such as working capital or making payroll. Bank loans aren’t designed to fund new hires and product development that would fuel your company’s growth. A business loan from a bank is simply meant to be a rainy-day fund—not a fund for you to change the weather.
4. A bank loan is the cheapest form of capital
If you can qualify for even a small bank loan, you should go for it. Other than borrowing money from friends and family, banks will undoubtedly give you the lowest interest rate. Because traditional banks borrow directly from the Fed (which charges banks almost nothing to borrow money in order to encourage lending and foster overall economic growth), banks have the lowest capital cost of any lender in the marketplace. In addition, since banks are focused on making safe collateralized loans, they don’t need to price in much risk.
Bank loans can be challenging to get and it’s unlikely you’ll qualify for as much as you need. At Lighter Capital, we believe you should have better options to fund growth. Our revenue-based loans allow early-stage tech companies to borrow growth capital while preserving the entrepreneur’s personal assets.
Gearing up to fundraise?
This guide explains explains the most important components of a successful fundraising strategy and how to prepare.