Bank loans are appealing to startups who worry about the “loss of control” associated with offering equity. However loans may have restrictions that can be as painful as giving up a board seat to an investor.
For example, many loans (and all SBA 7(a) backed loans) require a personal guarantee when other assets are insufficient to fully collateralize the loan. This often means a claim on your personal residence or your spouse’s discretionary income. Banks may also demand a specific debt service coverage ratio and regular certification before you can tap your credit line. And then there is the need to make regular cash payments regardless of how rocky your start-up’s cash flow is.
Moreover, banks will probably look at both your DUNs and your personal FICO score. (FICO’s Small Business Credit Scoring Service is more nuanced and based on more credit indicators than FICO, and some banks are thankfully moving in this direction.) In other words, to get good rates you need glowing numbers on more than one measure.
Given these hurdles, many entrepreneurs have started to look at alternative finance options like P2P lending. How do these stack up against loans? Peer to Peer lending often has fixed interest, a simple online application, and no pre-payment penalty. However, they have higher rates than traditional bank loans (9-36% as opposed to 5-12% APR). Your financial data may also be made public and it can be difficult to get the full loan request with a mediocre credit score.
Invoice financing converts outstanding invoices into immediate working capital and includes providers such as blue vine and Fundbox. This form of lending is flexible, quick and easy to qualify for, but has even higher rates (in the region of 28-60% APR). Alternative merchant financing (such as PayPal working capitala and kabbage) has very quick approval but often requires a minimum amount of steady sales to qualify. Like invoice financing it has some pretty steep rates (in the range of 30-50%, although PayPal WC rates are slightly lower, around 10-30% APR).
With traditional merchant cash advances a business sells future credit card receivables in exchange for a lump sum payment. These have high approval rates (about 50%), require limited documentation and have no personal liability. However their rates are the highest of the bunch, around 80-120% APR depending on the quality of your receivables.
As you can see, debt financing for early-stage companies can be hard to get and/or expensive. Costs may also be higher than reflected as my numbers do not include difficult-to-calculate fees and charges.
So what is a budding entrepreneur to do? If you do not have a stellar credit score, try and finance yourself using the traditional route: bootstrap as much as possible! This is not the most exciting route but it could mean the difference between success and bankruptcy.
Achieving your dream more slowly is better than having it morph into a nightmare.
Article written by Krista Tuomi.
Krista Tuomi is a professor in the International Economic Policy program at the School of International Service, American University. She has worked as a policy analyst in the areas of innovation and investment, and recently her focus has been on best practices in the startup investment climate, particularly on policy related to angel investing, crowdfunding and seed financing. Her passion for the field of innovation and entrepreneurship extends into her volunteer work, which includes SCORE, Boots to Business, the Veteran Small Business Challenge Competition, Syracuse’s Institute for Veterans and Military Families, and the Angel Capital Association.
Initially published on Bizwomen.