Start-up Due Diligence for Commercial Lenders

by: Smith and Howard

October 14, 2015

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Lenders who provide a helping hand to entrepreneurs stand to become trusted advisors as the business grows. But which start-ups are worth the risk? And how can you build long-term customer loyalty?

The art and science behind start-up due diligence for commercial lenders

With mature businesses, lenders can rely on business credit scores, financial statements and tax returns to gauge creditworthiness. But start-ups have only limited operating histories. In fact, many have never generated positive cash flow — or even revenues.

Without history to guide the way, entrepreneurs may instead provide business plans to help persuade banks and private individuals to invest in a start-up venture. Experienced lenders know how to spot the clues that a start-up is worth the risk.

For example, whether an entrepreneur has put together formal financial projections to accompany his or her business plan can provide insight into the most important determinant of a start-up company’s ability to succeed: the caliber of management. Other important considerations include the start-up’s competitive advantage, business type, market size and potential growth opportunities.

Life cycle of a start-up

The stage of development is also an important factor. Each stage has different implications for the company’s credit standing:

Stage 1. In the seed stage, the entrepreneur simply creates an idea and venture capitalists and other investors provide seed capital or first-round financing.

Stage 2. At this early stage, the company continues to develop a product or service to test the concept and seeks further financing.

Stage 3. The start-up graduates to a later stage when key development milestones have been met and the product or service is fully developed but not yet earning revenues.

Stage 4. Here the company is earning some revenue but is still seeking mezzanine rounds of financing, possibly leading to negotiations for an initial public offering (IPO).

Stage 5. At this point the company is earning revenues and has achieved some positive cash flows, possibly (but not always) leading to an IPO or sale.

Stage 6. The fully fledged company has established profitable operations.

As a start-up evolves through these stages, lenders and investors agree that the company’s risk typically decreases and its creditworthiness and value grow.

Encourage every prospective commercial customer to apply for a loan — even if it’s just a small one — as early as possible in their business cycles. Doing so starts its credit history. And this makes it easier for the entrepreneur to apply for credit when he or she really needs to hire employees, build up inventories or expand the company’s facilities to meet demand for a new product or service.

Conflicting points of view

Entrepreneurs and lenders are often at odds when it comes to gauging risk. Owners may want to draw cash from the business — in the form of salaries, bonuses, dividends or perks — to compensate for their “sweat equity,” research and development costs, and forgone compensation. These cash outflows may compromise a start-up’s abilities to service debt and reinvest in the business, however.

The further along a company progresses in its evolution, the higher an owner’s confidence is likely to be. But this exuberance can translate into unrealistic expectations about the amount of financing, interest rates and terms that the business should qualify for.

Lenders may be understandably gun-shy when it comes to lending to start-ups. They’re usually skeptical and sometimes want to discount financial projections prepared by rookie business owners. Lenders want to minimize risk, and not only through higher interest rates. They’re also likely to demand restrictions on the entrepreneur’s actions, personal guarantees and other restrictive covenants before approving a loan.

Benefits of CPA input

To help support lending decisions involving start-ups, ask prospective borrowers to consult with CPAs when generating their business plans. These independent professionals can blend an entrepreneur’s rose-colored financial projections with the lender’s concerns, using marketing data, industry benchmarks and other objective data sources.

Have questions about start-up due diligence for commercial lenders? Or, are you looking for more information on our commercial lender services, including SBA valuation? Contact Marvin Willis at 404-874-6244 or fill out our form for more information. 

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