Many start-up founders who are looking for funding run out and pitch their opportunity to anyone who will talk to them. I get it. However, unless they are strategically targeting the right type of money lender, their fundraising efforts may be in vain. When deciding where to spend your time: deciding investor vs bank loan, it’s important you know how each works. Knowing will allow you to go to the right one – the one who is the best bet for getting the startup capital you need for your new business.
Special thanks to Jonathan Mills Patrick – entrepreneur, business advisor, author, marketing executive, and former C-level executive in the banking industry. Some of the information used to research this article comes from my interview with him. You can listen to the interview using the link above.
“As a general rule of thumb, lenders are ‘historical-looking’ while investors are ‘futuristic-looking’.” – Justin Goodbread, CFP®, CEPA®, CVGA®Click to tweet
Now that you’ve written out a business plan, stabilized your personal financials, selected an advisory team, and chosen a business entity for your start-up, it’s time to look for a source of startup capital. Yet, you don’t want to run out blindly searching for money. If you look to the wrong people or places for funding, you could become discouraged by refusals.
As a general rule of thumb, lenders are ‘historical-looking’ while investors are ‘futuristic-looking’. On one hand, lenders want proof that a business is already succeeding. On the other hand, investors are interested in a business’s potential for success. Lenders want to see your ability to repay a loan, whereas investors are willing to wait for a return on their investment. So let’s dive deep into what specifically lenders and investors look for when considering funding your startup.
Fundamentally, lenders like banks want to see that you have the ability to repay their loans. Honestly, they aren’t interested in ideas and promises. Instead, they want proven facts and figures. They make their money off of interest rates. Therefore, they want historical proof that you make your principal and interest payments on a regular, timely basis. Not only do they want proof that you have made regular, timely payments; they want proof that you can continue to make those payments.
So how do you prove you can make loan repayments? What do lenders look for when considering giving you a bank loan to fund your startup?
Essentially, banks want to see steady, predictable income. What are your revenue streams? If you’re already in business, they’ll look at your operating statement, or your profit and loss statement, to tabulate your income and your expenses. Obviously, lenders want to see that your income exceeds your expenses. They want to know that you have enough money coming in monthly to cover the costs of the loan and your current operating expenses.
However, if you haven’t started your business yet, lenders will be looking at your “ordinary” income. While you’re starting your new business, will you continue to work another job? Is that job stable? Is the money you receive there predictable? Do you have money coming in from investments? Can you afford to make loan repayments, live your life, AND invest monthly money into your start-up business? Where do you get your capital?
Besides looking at your ability to repay, lenders will traditionally look for a secondary source of loan repayment. They want collateral. In other words, if you don’t make enough to cover your monthly payments, can you (or they) recoup cash from an asset? Do you have a vehicle, a boat, a house, a piece of property, a piece of equipment, machinery, or other things you can sell? Will their cash value cover loan repayments?
Again, lenders want security. Sure, you may have monthly income sources and collateral, but do you also have cash in the bank? Do you have liquid assets in checking accounts, savings accounts, CDs, money market accounts, security bonds, or the like that you can use to make your loan payments? Are your liquid assets enough to cover the entirety of the loan? Can they cover 50%, 70%, or 80% if necessary?
RELATED READING: How Much of a Cash Reserve Does My Business Need?
Ideally, lenders want to know that your business has been and is successful. They want you to have enough business and industry experience to remain successful in your field. They’ll look at your personal and business resumes. What have you done? What have you produced? Are you leading your field in manufacturing, production, or sales? Have you received any honors, awards, or certifications? Do you have enough financial and business know-how?
If you haven’t started your business yet, lenders will ask about your experience in your start-up business’s industry. Are you a dentist who’s been working for another practice and now wants to start your own? Did you recently graduate with a degree in horticulture, and are you looking to start a landscaping business? Do you have the experience you need to be successful? Or, are you jumping from one industry to another? Are you a salesman making a leap into the world of manufacturing? Basically, lenders want to see that you have some sort of industry or business experience to keep your start-up afloat.
Finally, and most importantly to some, lenders want to see your business plan. Many will even skip straight to the Financial Projections section. If you’ve been in business, they’re looking to see realistic projections based on historical facts and figures. They want to see your historical growth to compare it to your forecasted growth. If your revenue has increased steadily at a rate of 7-8% per year over the last 10 years, then most likely, they’ll expect to see a 7-8% projected growth rate over the next ten years.
However, if you haven’t started your business yet, all you will have is future forecasts. You won’t have historical facts and figures. For lenders to consider loaning you startup capital, you must have realistic sales and revenue predictions. Therefore, rather than looking at non-existent historical and unpredictable forecasted projections, they’ll look to see if you’ve researched your marketplace. Have you developed your products? Do you have a marketing plan in place to reach customers? Have you chosen the “right” business entity? Have you hired talented individuals who can strengthen your weaknesses?
RELATED READING: What Should Be in a Good Business Plan.
Knowing lenders want to see that you have the ability to repay their loans, investors want to see that you have the potential to make a return on their investment. They understand that they’re taking a risk. They’re loaning money (sometimes taking an equity stake in the company) to entrepreneurs based on ideas and efforts rather than historical facts and figures. However, these investors are hoping their risk will pay them back in high returns.
So what do investors want to see in order for them to consider funding a startup?
First of all, investors want to see your big idea. Instead of turning straight to your Financial Projections, they’ll be looking at your company description, your product and service descriptions, and your market analysis. What is your business? What does it look like? Who’s running it? How is it structured? What products or services are you offering? What marketplace needs are you meeting? How do your products or services differ from what’s already in the marketplace?
Essentially, investors want to see that you have a well-thought-out plan (called a “pitch deck” for investors). They don’t want to invest in an idea that will never come to fruition. Instead, they want your idea to be developed and even tried, if possible. They want to see your business goals and the strategies you plan to implement to reach those goals.
Additionally, investors want to believe in you, not just your idea. They want to see your passion and get caught up in your excitement. Can you prove to them you have the drive and wherewithal needed to start a business and keep it going? How much work have you put into the business already? Have you invested your own money? Are you pouring your own time and resources into the idea to show that you believe in it?
Now is not the time to be an absentee owner. If you’re seeking capital investments, investors usually want to see you putting in your own blood, sweat, and tears. They want to see your investments into the company.
Enthusiasm and passion for an idea are one thing, but qualifications are another. What degrees, certifications, or experience do you have in business or in your business’s industry? Do you bring intellectual capital to the table? Are you the inventor of the product or idea you’re selling? Do you possess patents or copyrights on your inventions or products? Can you procure product licensing for any patented products? How far can your intelligence take the company, and can an infusion of capital take you further?
Investors also want to see what preparations you’ve made to start your business. Have you done research and development? Have you tested prototypes or sales in your marketplace? Do you have any product pre-sales or purchase orders? Are you in contract negotiations with national retail chains? What do you expect your profit margins to be? Are your business plans realistic given current market trends and economic conditions? Do you understand your market and industry?
At the heart of investments is the hope for a significant return on the investment. Most investors are hoping to put their money into the next Google, Yahoo, or Amazon. Ideally, they want to invest in a start-up company that has the potential to become a larger-than-life, publicly traded company. They’re asking you about your products or services, and they want to see visions of dollar signs dancing in their heads.
Yet, how do investors know if your company has that kind of growth potential? Can anyone predict whether a company will succeed or fail? Actually, yes. Many investors can determine whether your company has the potential to grow and succeed by your company’s scalability. Okay, well what is that? In essence, scalability is the capacity to expand your business according to market demand. In other words, do you have management systems, team members, and product solutions in place that will help you increase sales and revenue while maintaining or even decreasing costs? Can you streamline or outsource manufacturing? In order for your business to succeed, you must be able to keep up with the demand for your product and services while maintaining your profitability. In essence, scalability leads to profitability, which leads to a return of investment for the investor.
Finally, investors sometimes don’t charge interest on monies they loan or give to a company. Instead, the cost of their investment is a stake in the business’s equity or ownership. Often investors are hoping that the influx of their capital into the company will help the business achieve stratospheric growth over a relatively short amount of time. Therefore, they “want in” on the profits the business’s scalability achieves for owners. Therefore, they may ask for a percentage of your owner’s equity or a percent of the shares of your stock.
Throughout my years of working with businesses and business owners, I’ve found that lenders tend to loan money to existing, proven businesses while investors loan money to proprietary start-up businesses. In other words, banks usually lend money, and “sharks” invest money. So which sounds right for your startup… an investor or a bank loan?
Identifying whether you can get a loan or an investment is the first step you need to take when you’re searching for ways to fund your start-up business. For more information about additional ways to find investors’ money, read our next article: 12 Types of Investors That Can Help with Funding a Startup.