When business owners want to obtain a loan, it’s overwhelming to know where to start or what to do. It breaks my heart to see a business owner apply for a startup loan when many banks don’t even make them. But why don’t banks loan to startups?
All banks follow a guideline that bankers call the 5 C’s of credit:
- Character– Is this a person of integrity who will pay the loan back?
- Cash flow– Does this business have at least a 3-year history of cash flow that can pay back the loan?
- Collateral– Is there sufficient collateral (margined) to fully cover the loan?
- Credit– Is there a business credit history of paying back loans successfully?
- Conditions– What are the prevailing economic conditions and are they favorable for the loan?
Of course, a startup does not have historical cash flow to pay the loan back and doesn’t have a credit history of paying back loans. So, 2 out of the 5 are a no. Further, if you’re trying to obtain this loan during COVID, the bank would likely conclude the prevailing economic conditions aren’t favorable either.
However, there may be a few banks who are willing to make the loan. Most start-ups are financed through an SBA program (most often the 7a program). This means that the SBA has their own specific guidelines that the bank combines with their guidelines to make the loan. Things they may look for are:
- Cash flow. As mentioned above, banks typically want to see 3 years of profitable operations. This means they want to see an income statement with positive cash flow sufficient to pay back the loan with a cushion. For a startup seeking an SBA loan, the lender will require monthly projections year 1 and annual projections year 2 since historical financials are not available.
- Collateral. A little-known fact about the SBA 7a program is that the lender has to put forth best efforts to fully secure the loan with margined collateral. If the business doesn’t have sufficient collateral to secure the loan, the bank is required to obtain additional collateral from the owner’s personal assets. For example, the bank may take out a deed against the business owner’s house as a 2nd mortgage, as long as there’s equity.
For example, if the loan amount being requested is $500,000, then you may need $600,000-$650,000 of collateral to meet the bank and SBA’s margin requirements.
With cash flow, credit, and conditions working against you, it might be difficult to get a bank startup loan today. However, if you can fund the capital yourself, you could get your business up and running that way. Then if your business continues to grow, you may be successful obtaining bank financing later with a year or two of operations under your belt and a better economic environment.