If a person looked only at Hollywood depictions of Silicon Valley, it would be easy to assume that all startups are backed (or want to be backed) by venture capitalists. But VC has actually become less attractive since investors began scrutinizing prospects more closely and offering tougher terms. As a result, many entrepreneurs are turning to bank loans, preferring to take on debt instead of trading away equity.
In fact, Bloomberg reports that loans to startups spiked by 19 percent in Silicon Valley last year.
While investor cash enables startups to grow quickly, many entrepreneurs have come to value control over time. They've come to prefer using their personal homes, bank accounts and other tangible goods to secure business loans over sacrificing even a modicum of control to investors.
The problem is, however, that if they lose the business, they also lose the personal assets they put up for collateral. Of course, if their companies don’t make money, they'll lose their possessions anyway -- or so the thinking goes.
But the calculation isn’t that simple. Sure, retaining control is desirable. But banks are in the business of creating wealth for themselves. Collateral guarantees they won’t lose money on business loans, and borrowers can be sure that if they don’t pay, the banks will collect.
The good, the bad and the reality of bank loans
Business loans are a win for banks. If borrowers fail to make timely payments, lenders can seize their homes or other assets and sell the properties to recoup the principal and then some. Meanwhile, the entrepreneurs have lost their businesses, houses and who knows what else.
But business loans aren't always a bad idea. If borrowers make their scheduled payments, they cultivate trust with lenders, making it easier to secure credit in the future. Once a loan is repaid in full, the bank will likely lend to the borrower again, possibly without requiring personal assets as collateral.
Another benefit is business credit. A loan repaid in good standing will boost the company’s score and make it easier to access credit lines and spending accounts. Businesses also tend to receive loans with lower APRs or fixed payments. The fact that the money is being used to grow a company gives lenders an incentive to offer competitive borrowing terms.
Entrepreneurs considering taking out bank loans can use the following guidelines to avoid critical mistakes in managing their business and personal finances:
1. Conduct an honest financial assessment of the company.
Take a deep look at what the business needs. Tools such as the Working Capital Needs Calculator shed light on the true costs of expansion, as well as indicate which areas show promise and which are dragging the company down. Be realistic about how much is needed, and ask for that amount. Don’t live outside the business’s means.
Getting clear on the business’s financial situation can prevent a business from ending up with payments it can’t afford. The Pennsylvania-based Plaza group’s financial troubles should serve as a cautionary tale. The company missed a $67 million balloon payment on a property loan, then had to scramble and renegotiate the terms to avoid default. This is a damning situation for any business, let alone a fledgling startup.
2. Don’t overborrow.
Resist the temptation to take the extra $10,000 the bank offers to tack on to a loan. The few hundred dollars it adds to monthly installments may seem manageable now, but those payments could become unwieldy. With a carefully planned budget, there's no reason to take more than the initial ask.
Here’s what happens to people who borrow more than they can afford. A 24-year-old woman was forced to the brink of bankruptcy after borrowing $6.5 million she couldn’t repay. The bank approved the financing despite the fact that her income didn’t match the loan and her investments carried considerable risk. The bottom line: Just because money is on the table doesn’t mean it's a good idea to take it.
3. Separate personal and business finances.
Never co-mingle business and personal bank accounts. Separating finances helps you avoid headaches when categorizing expenses, so it’s smart practice from a bookkeeping perspective. But the separation also protects any personal assets during business loan disputes and shields personal finances from examination by banks, accountants and the IRS.
The IRS has significant power to examine personal accounts when auditing business and investment deals. The Bitcoin exchange Coinbase found this out when the IRS demanded data on millions of customers who it believed were noncompliant. Coinbase resisted the IRS’s order, but the situation illustrates the importance of a clear separation of finances and stringent compliance practices.
4. Prioritize business loan payments.
The first bill to be paid each month should be the company loan installment, especially if there are any personal assets on the line. The company can do without some amenities for a month or two, but if a loan payment gets missed, the results could be disastrous. Going without a home is a lot more traumatic than having to go without cable.
Entrepreneur Jesse Genet knows this well: She repaid tens of thousands of dollars in student loan debt while running a successful business. She prioritized her startup’s expenses over her own and admits to having struggled with mounting credit card during lean months. However, her aggressive saving and debt repayment strategy enabled her to bootstrap her company while paying off her debt -- a feat made possible by clear priorities and a disciplined approach to finance.
A business loan constitutes an enforceable contract, even when the collateral takes the form of a family home or vehicle. Losses may feel personal to the borrower taking the hit, but banks aren’t in the business of being personal. They give loans to make money.
So, as long as entrepreneurs are clear on the stakes -- and prepared to make good on their loans -- they can earn from a bank relationship, as well.