Lately, I realized I could not answer a seemingly simple question: how much debt can a startup raise besides an equity round?
The key principle of debt is to consider present cash flow and anticipate future cash flow to calibrate the right amount of debt. Think of money borrowed to buy a house: the maximum amount of money you will be able to repay will be directly linked to your future revenue.
But what happens when a company (1) is generating no or low level of cash flow and (2) is very hard to predict?
I’ve asked several bankers to help me figure out how they were approaching loan request for companies that were not profitable, and precisely what was their decision-making process? Let me share my discoveries.
Before all, let’s get back to some finance basics. Finance is a way to give means in the present for future development. It deals intrinsically with uncertainty. Consequently, any investor (equity) or lender (debt) will always have in mind a reward/risk ratio.
In a market sufficiently liquid and efficient, there is a natural link between reward and risk. If it’s risky, investors will want to have greater rewards, since there are many paths where they could lose money — it’s what we call a risk premium.
All backers don’t play with the same rules. When you buy equity, you are faced with a complete range of outcomes from the worst (losing all your money) to the best (significant increase of share price or high dividends over time). On the contrary, when you borrow debt, your upside is limited to the full payment of the capital and the interest. Consequently, for a debt lender, you need to control the risk since the reward is limited: you cannot afford to lose too much.
Having that in mind, let’s get back to our question: how much money can lend to a startup. Or said another way, how much risk can a banker take with a company far from being predictable and profitable?
Why Taking That Risk First?
The thing with startups is that they can grow very fast. In a couple of years, a startup can go from a lousy client to a very satisfying one (generating a high level of a banker’s Holy Grail: net banking income). It is also a way to get close to innovation (which is desirable in many ways, from reputation purposes to the understanding of new business models and needs) and may lead to other business opportunities (M&A, structured finance, private banking…).
In this way, lending money for a banker is not only intended to earn sheer interests but also as an overall investment. And, as you can guess now, the first instinct will be looking for ways to limit the risk exposure.
How Bankers Can Limit Their Risk Exposure?
In France, there the sovereign public bank (BPIFrance) offers counter-guarantees to private banks, up to 70% of the total loan, which is a big incentive for banks to be active in that area. However, the conditions are numerous, so no bankers can confidently rely entirely on this risk coverage — which is very healthy (unfortunate things happen when risks aren’t taking into account, you can think of almost any financial crisis).
Besides that mechanism, bankers have to play with the standard market rules. They have two main levers to control risks: (1) they can ask for collaterals or (2) they can design their loan to maximize the odds of repayment.
Speaking About Collaterals
The first pillar of risk control is collateral. Collateral is an asset that a borrower offers as a way for a lender to secure the loan. If the borrower stops making the promised loan payments, the lender can seize the collateral to recoup its losses. For a company, it may be any type of asset, tangible or not. You can think of cars, pieces of furniture, electronic devices, and so on.
Let’s consider several options the banker has for startups:
- Tangible asset: most startups don’t have much immobilized, excepting electronic devices. Yet you have to consider two main aspects when putting devices as collaterals: (1) the price tends to decline very fast, and in a 5-year loan, most of the value will be eliminated, (2) the process is very long, item-specific and quite pricy (everything must be specified: manufacturer, price, item identification number, insurance, length of validity (you cannot freely choose how many years the item will be set as collateral, so it may not fit the loan duration, requiring the banker to relaunch a new process), etc.). Thus, for a large company, it may be worth doing it but for small startups, the costs of the overall procedure and the expected return don’t match.
- Intellectual Property: the false good idea is to put patents as collateral. Yet no external investors will be willing to invest in the company is the IP isn’t in its entire possession. So it would be a death sentence for a company in need of external money for growth and survival.
- Cash: Yes, I’ve said it. You could imagine putting cash as collateral for your cash. In fact, it would be the equivalent of a debt covenant demanding the full immediate repayment. But when you dig further into it, it does not really make sense: if the company has no cash to repay a monthly payment, you ask for all the future ones. It’s once again a death sentence (and a judge would invalidate such collateral in France).
- Personal Guarantee: it’s tempting for a bank to ask for a personal guarantee, meaning that the founders will be personally liable for the lease or loan obligations of your business (for capital, interest, legal and other fees). Yet for such uncertain businesses, it is very unfair to ask such level of risk for founders. So no bank should do it.
- Stock-in-trade (“Fonds de commerce”), which has no real equivalent in the Anglo-Saxon world, which would be in that sense equivalent of a part of the goodwill, as intangible assets. It has not much value for a startup but it can be a condition for counter-guarantees.
All in all, there is no true acceptable collateral for startups, excepting the stock-in-trade, which isn’t much but can lead to the obtention of other guarantees.
What a Banker Do Is Always Within His/Her Scope of Possibility
Before digging into the main topic, let’s just understand the environment of the banker as a decision-maker. Bankers dedicated to professionals have a portfolio of clients proportional to the size of the accounts. Local bankers will handle SMEs and self-employed (such as physicians or lawyers) and can have the responsibility of around 200 clients. When the turnover is between 5m and 50m, the portfolio will decrease to around 100–120 clients. For companies larger than €50m of turnover, the bankers will be located in “business centres“ and take care of less than 80 (the bigger, the fewer). As a consequence, bankers lack the resources to realize in-depth due diligence for every company.
Depending on the profiles of the company, bankers will have more or less latitude to set up the loan and its conditions. Even in the right environment, a banker will have to present the lending proposal to their risk committee, which will reject or approve it. Above certain thresholds, they will require also the validation of their operational manager on top of the risk committee.
How To Design Your Loan The Best Way Possible
For startups, the typical possible loan offered by a private bank has a size of up to 30% of the last round of equity, will last 5 years, and put at risk around 50% (+-10 points) of the capital, considering the cash in the bank and monthly burn. The sooner you contact your banker after you raised equity the easier you will get a loan.
The heuristic used will imply three main components:
- the quality of the relationship between the clients and the banker (is there a good level of trust?),
- the quality of the business plan (is it thorough? realistic? easy to read? is profitability at sight?),
- the quality of the investors (are they famous? are they known for the seriousness of their due diligence? are they often reinvesting in their companies or helping the company find further rounds of investment? do they have the ability to make a bridge financing round? ).
Then many variables will impact on the decision and the parameters of the loan, such as:
- how long are the sales cycles?
- what does the team look like now? are the key profiles already in the company?
- how cash intensive is the business? (level of CapEx required)?
- level of uncertainty (product, market, technology, etc.).
- level of competition and defensibility in the business.
The banker will be quite autonomous at structuring the loan parameters (length, amount), yet (s)he will have to make a case to the risk committee (and sometimes also her/his manager). So as an entrepreneur/CFO, you’d better make the work as easy and efficient as possible.
How To Maximize The Loan Approval?
You should send to your banker a document which is as close as possible to the memo (s)he will have to make. You can very openly ask what kind of information is needed to make her/him save times. Oftentimes, the structure of the document looks like the following:
- business description (short description then longer one),
- the maturity of the business (traction, key milestones reached and high-level corporate roadmap),
- clients, sales cycle and key unit economics,
- competition and differentiation (btw speaking about that topic, check out this article to avoid the worst slide found in 99% of decks)
- business plan (xls), with the key assumptions, highlighted and explained (eg: finding base rates)
- risk factors (check out how big companies are describing such risks in their S-1 by search in Google “public company S-1 SEC”)-
- how to cover the risks and limit the downsides
- cash need and use of proceed (you can add the description of your recent equity round)
Now that you understand the banker perspective, objectives and constraints, you just need to do the work.
Aim for a loan amount of roughly 30% of the last round of equity. And remember, the sooner you contact your banker after you raised equity the easier you will get a loan.