The biggest hurdle in obtaining a startup business loan is convincing lenders that your business, without an operating history, is worth the risk. Most banks want to see three to five years of proven operational success before they consider lending money. This requirement puts startups in a challenging position since they lack the very experience lenders rely on to assess risk.
However, the good news is that you can still get a startup business loan—if you approach it strategically. Unlike businesses with an established history, your financing will likely involve “stacking” multiple funding sources to arrive at the amount you need. This means combining bank financing with other sources like vendor trade credit, customer down payments, or even investor contributions.
The key to getting a bank to approve your loan boils down to three main factors: confidence in you and your team, your financial projections and your collateral and guarantees. First, the bank must believe that your sales ramp-up projections are reasonable. Essentially, they need confidence that you can reach cash flow targets fast enough to meet their minimum debt service ratio requirements before your funds run dry. Second, you need to have sufficient collateral or guarantees in place to ensure that the bank will be repaid even if the business fails. Banks want a safety net, and your collateral—whether it’s assets you own or a third-party guarantee—provides that security.
Remember, bank financing is typically just one piece of your overall strategy. Before diving into any financing plan, you must build an accurate pro forma income statement and a cash flow statement. These financial statements help determine exactly how much money you will need, factoring in both startup costs and working capital requirements—taking into account your “burn rate.”
For startup entrepreneurs, understanding your “burn rate” is not optional—it’s vital.
In a startup context, the “burn rate” refers to the rate at which your business uses up its cash reserves to cover ongoing operational expenses before achieving profitability or securing additional funding. It represents the amount of money you’re “burning” each month to keep the business running.
Your burn rate is typically calculated based on your company’s monthly or weekly net loss, including operating expenses, salaries, rent, utilities, marketing, R&D, and all other costs. This metric helps you and your investors understand how long your current cash reserves will last, which is known as your “cash runway.”
Monitoring your burn rate is crucial for a few reasons. First, it gives you a clear picture of how quickly you’re using available funds. This allows you to adjust spending if it appears that you’ll run out of cash before reaching profitability. No startup wants to be in a position where they need to approach investors for more money out of desperation, especially if they haven’t demonstrated financial responsibility up to that point.
To determine your burn rate—and by extension, how much funding you’ll need before reaching profitability—you must build a pro forma income statement and a cash flow statement. I go into detail on these topics in my Guide, “How to Start and Finance a Business Even if You Don’t Have Any Money”.
Calculating your burn rate is also about assessing whether the cash required to start your business is truly worth it. You don’t want to discover you’re pursuing the wrong opportunity after you’ve already burned through valuable resources. It’s always better to conduct thorough research first, so you can avoid being stuck with a failed deal and no cash left for a second chance. My Guide will take you step-by-step through this research process so you can make informed decisions from the start.
Another key component of your financing strategy is understanding your Debt Service Coverage Ratio (DSCR), often simply called the debt service ratio or debt ratio. Banks use this metric to determine how much debt your business can afford to service, including both principal and interest payments.
The DSCR is calculated annually before taxes. To determine it, you need to add net operating income, non-cash expenses (depreciation and amortization), and interest expense, and divide that by the sum of interest expense, principal payments, and lease payments, if applicable.
Breaking this down:
For instance, if a bank says they require a debt service ratio of 1.5, they mean that your net operating income plus depreciation and amortization must be at least 1.5 times your total debt obligations.
Please note a DSCR analysis is not just an exercise to get a bank loan. It’s critical for you as an entrepreneur to understand DSCR, especially when negotiating any type of financing. Suppose you are considering a private loan but realize your DSCR is only 0.5 given your other debt service obligation — you simply won’t be able to meet your obligations. As a rule of thumb, a DSCR of 1.5 is typically the minimum required to comfortably cover your debt.
Most startups will not be able to immediately cash flow their operations and their debt obligations. This is referred to as a Cash Gap. This is why understanding your projected debt service ratio is so important. You need to know when your sales are expected to ramp up to meet your operation expenses and your debt service requirements.
The cash gap (also known as the cash flow gap or cash conversion gap), in the context of a startup business, refers to the period of time between when the startup must pay for its expenses and when it receives cash from sales or other sources of revenue. Essentially, it measures how long a company’s cash is tied up in its operating cycle and how long the company must fund its operations without additional cash inflows.
In a startup, the cash gap typically arises due to the following cycle:
The cash gap is, therefore, the time difference between when cash goes out (expenses) and when cash comes in (revenue). During this gap, the startup needs to have enough working capital to cover its costs until payments are received.
For a startup, managing the cash gap is crucial because, in the early stages, cash flow is often tight. A long cash gap means that the business might need to rely on external funding (such as loans or investments) to cover the gap, which could create additional pressure and costs. Minimizing the cash gap by shortening payment terms with customers or negotiating extended terms with suppliers helps startups maintain a healthier cash flow and reduce reliance on external capital.
How can you bridge the cash gap? It varies significantly based on the type of business.
When I launched my America Way Car Wash, I was fortunate to have a positive cash flow in the first month, with a debt service ratio of 2.5 almost immediately. On the other hand, starting Natural Gas Turbine Technologies took several years before we even began approaching a positive cash flow, given the immense time and cost of product development. This difference underscores that each business has unique cash flow dynamics.
Banks, at their core, are in the business of “renting money.” To secure their support, you need to convince them that your sales ramp-up projections are achievable, that you’ll hit the minimum debt service ratio, and that they will recover their funds even if your business fails.
Several key factors influence your ability to secure a loan, including:
Not all these factors need to be in place, but you need enough strength across the board to reduce perceived risks from the bank’s perspective.
If the bank is comfortable with your business and your ability to execute your plan, the bottom line for the bank is how you will fill the cash gap and how you will protect the bank’s interests if your startup fails.
Approaching a bank the right way is key. If you walk in and drop a business plan on a banker’s desk without understanding their requirements, you risk painting yourself into a corner. My Guide covers in detail how to approach banks the right way.
If your credit score is lacking or you don’t have much net worth, you may need to rely on a third party for a loan guarantee. This is quite common in startup financing. In exchange for a guarantee, you may need to offer an equity stake in your business. Investors willing to provide a guarantee may also choose to limit their liability, which could mean bringing in additional guarantors.
Tip: Equity financing is the most expensive type of financing you can pursue. Do not offer equity in your company without running the numbers. Otherwise you may end up giving up too much equity in exchange for a guarantee.
Another common option for startup financing is obtaining a Small Business Administration (SBA) loan guarantee. SBA guarantees allow banks to take on more risk than they might otherwise be comfortable with. However, this doesn’t eliminate the need to meet the bank’s minimum debt service ratio—though it may lower it somewhat.
Typically, SBA loan guarantees cover up to 80% of the loan. But it’s important to note that the bank—not the SBA—sets the criteria for the loan. Therefore, banks can have different requirements, even with an SBA guarantee. For example, if your credit score doesn’t meet the bank’s standard, an SBA guarantee won’t necessarily eliminate the need for a personal guarantee from another party.
In my Guide, “How to Start And Finance a Business Even If You Don’t Have Any Money”, I explain 21 different financing options, taking you step by step through the startup process—from market research to building a marketing plan. This course will help you avoid common pitfalls and maximize your chances of success.
Securing a bank loan for your startup isn’t just about asking for money—it’s about presenting a compelling case that makes the bank want to invest in your success. To craft a successful bank loan strategy, you need to demonstrate that you’re prepared, realistic, and have mitigated the risks to both yourself and the lender.
Start by thinking like a banker. Your goal is to show them that:
But beyond these basics, what really matters is how you can build their confidence in you and your business. Banks are not just funding an idea; they’re investing in your ability to execute that idea. Show them you’ve thought through the details, minimized risks, and that you have a backup plan if things don’t go as expected.
Be thorough in your research, conservative in your projections, and realistic about the time it will take for your business to reach financial stability. The more proactive you are in addressing potential concerns upfront, the easier it will be to earn their trust.
In the end, a successful bank loan strategy is about more than just meeting requirements—it’s about creating a story of your startup that’s so well-prepared, credible, and compelling that the bank becomes part of your journey to success. Be the entrepreneur they want to invest in, and you’ll find the doors to funding begin to open.
Here’s to YOUR SUCCESS,
Neil
© 2024 Biz Startup Mentor
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