Which startups are worth the risk?

Entrepreneurship is the pinnacle of free enterprise, but almost all banks shy away from startups. The truth is, businesses in this segment are more likely to fail than not, according to the Small Business Administration. But there are a few bright spots that present lucrative lending opportunities for the diligent, adventurous lender.

What is a startup?

Startups are small businesses with limited operating history. They start as an idea that’s fleshed out with research and development. Then the business model is formulated and the owner(s) starts selling. Up to this point, most startups are funded by the owner’s personal resources, including savings, credit cards, retirement accounts and home equity loans.

Lenders frequently classify a business as a startup until it has operated for at least five years. But at about the two-year mark, lenders will consider underwriting a loan. Community banks have long been the mainstay of entrepreneurs. But some big banks — including Bank of America and Wells Fargo — are loosening their purse strings to startups.

Where to start?

What do underwriters want most from startups? Business plans should show that management has thought about potential threats and risks, such as seasonal cash flow shortages and hidden costs. But the proof is in the company’s actual results. Two or three years of CPA-prepared financial statements will give underwriters significantly greater peace of mind than a business plan alone.

Also evaluate the startup’s concept. Would you buy it? What differentiates the product (or service) from those of competitors? Entrepreneurs can be blinded by love for their concept. So, it’s the lender’s job to stay grounded and play devil’s advocate. A startup’s growth projections should jibe with historic results and industry trends.

Franchised startups also tend to bear lower risk than nonfranchised ventures. Large publicly traded franchisors (such as McDonald’s or Toyota) generally provide a proven business model and marketing support for its franchisees, especially in the startup phase.

What to look for in an entrepreneur?

More important than the startup’s concept is its management quality. In the wrong hands, even the best idea is doomed to fail. When evaluating the people behind the idea, consider their employment history, areas of expertise, credit scores and personal balance sheets. Personal guarantees, key person insurance policies, personal asset pledges, and co-signing are commonplace when lending to startups.

If a single-owner business is run by a technical expert (such as a former operations or R&D manager), who will handle administrative tasks (such as HR and financial reporting) as the business grows? Look for owners who admit their shortcomings and hire employees to supplement tasks outside their areas of expertise.

What other factors can improve a startup’s odds?

Ultimately, lenders want assurance that a startup will be able to repay debt, either from operating cash flows or personal resources. If your bank’s underwriters are sitting on the fence about a startup prospect, consider a little extra handholding to get the loan approved.

First, educate the startup’s management team about what your bank is seeking. Usually that’s a solid business plan, two to three years of audited financial statements, and operating results above specific profitability, turnover, leverage and liquidity levels. Specific financial benchmarks vary from industry to industry.

If possible, arrange for the owner(s) to pitch the company’s request directly to the underwriting committee and field any questions. Transparency on both ends of the lending decision can help push the deal through.

Also recommend Small Business Administration (SBA) loans to fence-sitters. For companies with less than $7 million in tangible net worth and $2.5 million in net income, SBA 7(a) operating loans and 504 equipment loans provide partial guarantees from the federal government in case of default. If your bank participates in these programs, an SBA-backed loan could be the final push that turns a “maybe” into a “yes.”

What’s to gain from startup loans?

Lending to startups won’t be easy, but it’s often worth the extra legwork. In addition to reaping higher interest rates for their incremental risk, startup loans reward diligent lenders with the satisfaction of helping struggling entrepreneurs make their dreams a reality and possibly gaining new long-term customers. With transparent communications and solid business planning, startup loans can be a win-win for both borrower and lender.