Wednesday, May 15, 2013

Bank loans not for start-ups

Starting up? Do you have a great idea that could be launched and transformed into a successful business? Let me guess. You need funding.
For many entrepreneurs a bank is the first place where they think to look. Unfortunately my experience has shown that even in normal times, which we are far from experiencing now, banks are quite risk adverse. Therefore, I would definitely not suggest for you to waste your time with one. Don't take me wrong. You could try as a way to learn from the experience. But doing the search with the hope of actually getting money will, in my opinion, be wasteful; especially when there are many other things that you need to get done to make your dream a reality. To understand why I am being so direct, think of loan opportunities in terms of what will you use to repay the loan.
  • Past sales - You can pay a loan with the money that you already have earned. The collateral is the money already in a bank. This carries the lowest risk for banks. As a result, they love them so long as the company has a good credit record. In reality, these loans are for businesses that have already succeeded and somehow found a need for cash. No, it is not impossible. Apple and its massive balance sheet in foreign accounts needed to borrow to pay dividends in the US without incurring taxes from importing its foreign cash, for example. But since you are starting up, you have no sales and have yet to earn any money yet. You must therefore be excluded from this type. 
  • Present sales - You can pay the loan when you get paid for sales that you are making right now. These could usually be Purchase Order (PO) loans or Factored orders. The collateral is the invoices being raised. In many cases, banks seek other collateral. The risk is now higher since invoices may not get paid for many reasons. Buyers could complain about the invoiced amount, the product quality, the method of delivery and many other things. Thus, many retail banks will not take on these loans, leaving you with having to seek commercial banks. Be ready, at this level, interests are not what make loans expensive. Fees can turn seemingly low interest loans into expensive monsters that will end up costing you an equivalent to 20% more in annualized interest. Here again, this may not for the typical start up. You do not even have the the inventory needed to attract the kind of buyers or the volume in business that would allow you to explore these loans.
  • Future sales - In this case, you would pay the loan after monetizing or selling the inventory that you have at hand. In other words, there are no sales yet and you are trying to use the inventory as the collateral. You are now far from most bank's risk profile. The answer you will most likely hear from bankers if you ask for these loans is: "if you can't sell you inventory, what makes you think that we can?" Obviously if you had prior success selling the inventory already, you would have no need for a loan, have the cash to back up a different loan or at least have the invoices from present sales. Start up or not, you are out of luck. 
  • Way-in-the-future sales - As in after I build a team and get a place to work from and get my idea turned into a great success and get CNBC to talk about it during Squawk Box. In other words, the idea and your enthusiasm, become the collateral. Good luck. The only banks that would touch these are those that issue unsecured loans: credit cards.
Now that you do not have to take my word for it. I found a great article titled How Entrepreneurs Qualify for Funding from Banks by Martin Zwilling that will surely prove helpful to you if you happen to the in the 0.1% of entrepreneurs. If nothing else, he does a great job describing the characteristics that will help you with all other sources of funds.
To me, the fact that banks are risk adverse means that they are a poor match for risk seeking entrepreneurs. Neither side is wrong; they are both just seeking different things. Banks are happy picking up pennies in front of a slow moving steam roller. Entrepreneurs want to swing for the fences even if it means striking time and time again. 
Financing is always risky; the difference lies in how risky it is. At the core of this distinction resides the separation between the patient capital that builds infrastructure and the risk-intolerant capital that rushes out of a country's financial markets at the first sign of trouble. These differences help explain why bank financing is far from normal today. The economy is flush with risk-adverse capital and lacks equity-underwriting patient capital. As a result, consumers and small businesses will have to pay large premiums for loans, if they can get loans at all. We should also expect to see many more flash crashes, where capital rushes out of the US towards other markets as was the case during the hacked AP Twitter account crash. To compound the issue, banks borrow money short-term and lend long-term. So the pervasive uncertainty about the nation's future does not help banking models. Perhaps one day in the future, when the country can find White House leadership that promotes a normal business environment while supporting entrepreneurship as opposed to punishing success, will banks begin offering real opportunities for new businesses. Until then, don't hold your breath and find other ways to fund your great ideas.

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