Three years ago, when John Manner and his co-founder, Arnold De La Fuente, created MavenNext, a ServiceNow process advisory and technical consultancy, they found limited options for startup funding.
“Because we’re service-based, and we don’t have any kind of products... we’re not a good candidate for any kind of angel investing or seed funding,” said Manner, co-founder and vice president of customer delivery. “If you’re doing a service company, yes, the startup costs are a lot less, but you’ve got to be able to bootstrap a certain portion of it to make it go.”
For early-stage startups, it can be challenging to qualify for traditional business loans given the considerable risks of entrepreneurship. To get off the ground, the MavenNext founders took advantage of invoice factoring. That’s where another company buys MavenNext’s outstanding invoices at a discount in exchange for paying them out immediately — no need to wait for a client’s check to come through to make cash flow and payroll.
Loans and Financing Options for Startups
- Personal loans
- Small Business Administration loans
- Peer-to-peer loans
- Friends and family loans
- Purchase order financing
- Asset-based lending
- Trade financing
- Rollovers as business startups (ROBS)
- Merchant cash advance (MCA)
“That was really the only option that we had at that time besides signing a personal loan based on our own credit history,” Manner said.
MavenNext later qualified for a business loan through PayPal’s LoanBuilder service, but it relied on the personal credit scores of the co-founders.
“If we didn’t have a good credit score, we might not have an option on it, or a worse percentage of interest,” he said. “They took a fairly large chunk because there’s certain risk to them as well.”
The next goal is to qualify for a Small Business Administration loan, Manner said. SBA loans are guaranteed by the government to reduce the risk for lenders who might be hesitant to lend to small businesses and startups.
With the COVID-19 pandemic, it was challenging to work with understaffed banks to apply for an SBA loan, but MavenNext did qualify for a COVID-19 Economic Injury Disaster Loan. EIDL provides economic relief through low-interest loans to small businesses experiencing a temporary loss of revenue.
Of navigating the loan application experience, Manner said, “Watch out for the high interest loans out there because usually what they do is they take their interest on the front end, so even if you pay it back sooner, you’re not going to get any kind of advantage with that,” he said.
Built In spoke with experts specializing in startup financing who shared their advice for securing funds to launch a tech company — read on to learn about the process.
Where Should You Go for a Loan?
Traditional banks offer small business loans, but the risk that comes with startups makes it unlikely for entrepreneurs with early-stage ventures to qualify.
“The difficult thing for a startup is it starts with nothing but blue sky. It’s an idea, but it’s more risk than a traditional bank can take for giving out funds,” said Rob Stephens, founder of CFO Perspective, which provides financial consulting and education to small businesses. “It’s tough to get traditional bank loans for startups. A lot of times you’re going to need two years of cash flow, two years of tax returns, to show that you really have something going here that’s profitable and to prove the credibility of your ability to pay back the loans.”
Entrepreneurs might find more luck with community banks who are more likely to make smaller loans to startups.
“With a smaller community bank, with local ownership, local decision making, they’re going to know a lot about the local area. They’re going to know a lot about the people and players in the local area,” Stephens said. “It’s easier to get the message across.”
“You may have a very profitable business, but if it’s not showing positive cash flow, then you have a big problem."
Startups might consider working with a microlender, a nonprofit organization that receives a loan from the SBA, and in turn, makes small loans to businesses in the community.
“Microlenders and community lenders are pretty much the only lenders that offer business loans to companies in the startup phase, if they need money for seed financing,” said Anna Serio, certified commercial loan officer and expert for Finder.com. “You can often find online Fintech companies that offer financing for businesses, maybe in the three- to six-months range, but these community lenders are really the only ones that I’ve seen that can actually offer a business loan to start your business.”
A benefit of working with a nonprofit or community bank is that they often provide management training programs and financial advice to the entrepreneurs receiving the loans. These institutions also usually emphasize supporting marginalized communities, Serio said.
While loans from community lenders tend to have interest rates higher than traditional bank loans, the rates are usually still lower than online bank loans for startups. Serio warns that they can have interest rates as high as 90 to 100 percent APR.
“Unfortunately, many entrepreneurs get sucked in with the online loan thinking that it’s a very low interest rate, when really, it’s much higher than it actually appears,” said Bill Haemmerle, who works with startup clients as director of transaction advisory services at the accounting and growth partner, Wiss & Company.
For example, Haemmerle says startups can take advantage of merchant cash advances, which can be helpful if you need funds quickly, but it will cost a lot of money. For instance, you might borrow $100,000 with an MCA but only get $70,000 in the beginning. In theory, the loan would have a 30 percent interest rate, but in actuality, as part of the deal, the lender deducts a portion of your sales on a weekly basis, bringing the interest rate closer to 80 or 90 percent.
Stephens adds not to underestimate credit unions as a potential lending source. “Many credit unions are growing their business banking and are a good place to consider. Compared to banks, you might find lower loan rates and higher deposit rates too,” he said.
What Types of Loans Are Available for Startups?
Entrepreneurs are likely to need to rely on their personal credit scores when starting a business if they do not have hard assets or an established history of sales, so personal loans are an option if they cannot qualify for business loans.
“These are based entirely on your personal finances and on your credit score. You’re also entirely responsible for paying back the loan, which is pretty risky for you because if your startup fails, and a lot of startups do fail, then you are kind of in a tight financial situation,” Serio said. “You could risk ruining your credit and defaulting on the loan.”
If a startup is a couple years into business like MavenNext, entrepreneurs can consider applying for an SBA loan, which allows banks to make loans to small businesses they might not otherwise be comfortable taking an investment risk on since the government guarantees the loan.
“A lot of people think… I have this idea, so I can get this government-guaranteed loan to make it happen,” Stephens said. “You still have to prove that you’ve got the ability to pay that loan back.”
Peer-to-peer lending is a financing option where entrepreneurs can obtain loans directly from other individuals, without using a financial institution. The borrower can usually access funds quickly, and the lender can earn a return on their investment.
Loans from family and friends are used slightly more than bank loans for early-stage startups, but there are considerable risks for this type of loan, said Stephens.
“Be very, very careful and make sure everyone’s really clear. Actually do paperwork and have a formal agreement for those. Everyone’s friends at the beginning, but when things go bad… you’ve got more on the line than the money. You’ve got the relationships,” Stephens said.
What Other Financing Options Are There?
Beyond loans, there are other financing options like invoice factoring, which MavenNext used. Similarly, with purchase order financing, a third party advances a startup’s purchase orders and takes over collecting for the receivables. Haemmerle says PO financing usually requires a personal guarantee and is a short-term arrangement with interest rates around 10 to 25 percent.
“Even though people get scared when they say they’re buying the receivables and controlling cash, factors are usually pretty good because they provide you with not only the financing, but then there’s analytics and software that they have behind it to look at your receivables and the performance of your receivables over time,” Haemmerle said.
He continues, “If you have companies that take a long time to pay, you need the cash because you’ve got other orders you got to fill, and you have other things you have to make, so you’re really trying to reduce that the concept of a cash-to-cash cycle, so that from the day I put a dollar out for merchandise to the day the dollar comes in, that I collect it, that's what I'm trying to finance with these types of these types of loans.”
Asset-based lending is another financing option where a borrower gets an advance based on the number of outstanding receivables or inventory – usually 50 percent of the value of the inventory of finished goods or raw materials, Haemmerle said.
“An asset-based loan, that’s probably the lowest rate you’re going to get,” he said. “It’s probably the best terms from a liquidity perspective.”
ROBS or rollovers as business startups allow you to tap into your retirement funds without tax penalty, but you will need to have at least $50,000 in your retirement account to qualify. The downside: You’re risking your retirement savings and you’d likely have to hire another company to handle the details because it can get pretty complicated, said Serio.
Trade financing allows you to work directly with your suppliers for financing to help with cash flow. “If you’re buying equipment, you can finance the equipment directly through the equipment dealers,” Stephens said. “It’s also sometimes really cheap because they just use the financing as another hook to get you to buy the equipment because they’re making the money on the equipment, not just on the loan.”
How Do You Increase Your Likelihood to Qualify for Financing for Your Startup?
A well-articulated business plan is key to improving your chances of qualifying for any type of financing.
“Having a business plan that is really solid and easy to follow is really important because your lender is going to take a close look at that as well,” Serio said. “You’ll definitely want to focus on financial projections because that will be the basis of whether or not you get approved a lot of the time.”
She continues, “Securing a loan with business assets can help you get approved, if you have them. If you don’t, you’re probably going to be required to give a personal guarantee, so make sure that you’re personally able to afford repaying the loan.”
Since so many loans for startups depend on personal finances in the early stages, be sure that your credit score is as high as possible.
If your business does have hard assets and you can prove positive cash flow, it might be easier to qualify for a loan.
“Loans are paid back with cash, not profits. So, you really want to focus on the cash flow of the business,” Stephens said. “You may have a very profitable business, but if it’s not showing positive cash flow, then you have a big problem because you have to pay back the loan with cash.”
Haemmerle encourages entrepreneurs to share their startup stories with all sorts of people — you never who might be interested in your idea have access to capital. “As an entrepreneur, you’ve got to be scrappy to make it work and not be afraid to get rejected,” he said. “The more people you tell you’re looking to raise capital, you never know where you’re gonna find it. If you believe in the idea, stick with it.”
Reflecting on MavenNext’s experience with pursuing financing, Manner said, “Make sure you read the terms. Plan for your loans well ahead of time. Having urgency around it is never a good thing.”
Depending on the amount of risk an entrepreneur is willing to take, that will influence the types of financing options available for consideration.