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TLDR
- A loan is an arrangement where an individual or entity asks for a sum of money from a lender in exchange for the promise of future repayment. Many lending entities tend to add interest on these loans which is additionally paid with the initial (or principal) amount.
- After approaching a bank to apply for a loan, you will be asked for some important information. This will include specific details like the reason(s) for the loan, your financial history, Social Security Number, etc. Most of this information will be used to determine your intent for the loan and your capacity to pay back the principal amount plus the interest.
- There are quite a few benefits of bank loans for founders: you get -- all or part of -- the initial capital needed to launch your startup, the ownership in the company remains with you, your personal wealth remains protected (as you don't have to bootstrap your hard-earned savings), and you get the advantage of good business credit.
- Bank loans can be used by founders when they are aiming for growth, covering up cash flow shortfalls, looking to grow the team, covering taxes (including late payments, penalties, and fines), and/or trying to ramp up production of their product/services.
- There are some great banks in the U.S. that offer loans to startups and small businesses. Notable ones among them are Wells Fargo Bank, Live Oak Bank, Huntington National Bank, and TD Bank.
How does a bank loan work?
The concept of loans is thought to be as old as the barter system itself. A loan is an arrangement where an individual or entity requests a sum of money from a lender in exchange for the promise of future repayment. The value of the repayment will generally be at least equal to the principal amount borrowed from the lender. Many lending entities tend to add interest on these loans which is additionally paid with the initial (or principal) amount. Loans can vary in type based on who you borrow them from.
In its essence, the process to secure a bank loan is fairly simple. After approaching a bank to apply for a loan, you will be asked for some important information. This will include specific details like the reason(s) for the loan, your financial history, Social Security Number, etc. Most of this information will be used to determine your intent for the loan and your capacity to pay back the principal amount plus the interest.
The information provided will then be reviewed by loan officers at the bank, who will primarily be looking to establish how much of your gross monthly income will go towards paying the debt -- this proportion is known as the debt-to-income ratio. Other information that they will be looking for is how deserving you are of receiving the loan -- and this is known as creditworthiness. Once the information is thoroughly scrutinized, the bank will decide whether to approve or deny your request.
If the loan is approved, then the bank and your startup will sign a contract that will include information regarding the loan. Both parties must agree upon all the terms included in the contract before signing it.
The contract will include information that includes (but is not limited to):
- Interest rates
- The maximum amount of interest
- Collateral details
- Period of repayment
Benefits of Bank Loans
Applying for a bank loan is a long process and the wait for being accepted can be quite harrowing for founders. However, if you can go through that tedious process and come out the other end successfully, then a bank loan can be very beneficial, especially for an early-stage startup.
Benefits of bank loans:
Initial capital
You will face many obstacles while starting a company. The day-to-day operations alone can be overwhelming for founders, especially in the early days. Among the most important resources required to clear the early obstacles is capital.
The amount of capital required for sustaining a startup depends on the type of company that you are setting up. Early expenses like inventory, office space, equipment, manufacturing, salary, etc., can quickly add up to a hefty sum. As a result, your savings and the funds raised from investors might not be enough to adequately bear your initial expenses.
If your startup is looking for a major early-stage investment (outside of angel investors, founder-launched funds, and VCs) then applying for a bank loan is a good idea. This way, you get the support of a well-established institution, which improves your portfolio and helps you to launch your venture on a positive note.
Ownership remains with you
There are few options available to an early-stage founder when it comes to bagging investments. Other than bank loans, the other common method of securing an investment for a pre-seed/seed-stage startup would be to bring in an angel investor.
Here’s the problem with that:
Rather than asking for the repayment of the principal amount plus interest, investors (including angels) tend to prefer equity. The stock that the investors own then becomes a means for them to exercise a certain level of control in the startup, which can become problematic for the founders. As investors start to voice their ideas and concerns, it may lead to a power struggle to determine who takes control of the wheel of the startup.
Taking loans from a bank, on the other hand, means that you will gain substantial capital without losing any control of the company. Another advantage is that in the future, you can carefully vet your investors based on their merits, connections, and expertise rather than solely their capital.
Personal wealth remains protected
Building a business from the ground up could end up requiring a lot of capital. Most founders avoid involving banks and prefer investing their savings in the venture. This sounds good in theory but has its potential pitfalls.
One of the common pitfalls is draining your savings. As a startup begins to develop and face certain obstacles, the monetary requirements could keep growing. The tendency of founders then is to liquidate more and more of their assets to keep the business afloat. It goes without saying that if things take a turn for the worse (which they tend to do more often than not at startups) then this path can only lead to a loss of all the savings that you invested. Taking a loan from a bank helps keep your individual wealth separate from your business capital.
Advantage of Business Credit
Starting and sustaining a business successfully involves thinking about the long term. While focusing on the present is important, eventually, an actionable plan for the future needs to be made.
Applying for a business loan (and then repaying it in a timely manner) can help you create a strong foundation for the future. Down the line when you plan on scaling your business, you will require -- among other things -- a good line of credit. Responsible credit behavior is an asset to be able to demonstrate in your portfolio. It helps instill some form of confidence in the lending entity, whoever they may be, that their money will be returned to them.
Applying for a small loan and paying it back boosts the odds of you successfully applying for a loan of a larger amount in the future. Another advantage is that with good credit, you should be eligible for lower interest rates.
When to Use Bank Loans
There are several good reasons why a startup can apply for a bank loan.
Some of these reasons are:
Aiming for Growth
After establishing a startup, the next step would be to scale up or grow your business. Many times, businesses reinvest their profits back into the venture with the prime goal of expansion. It is a good strategy, one which has helped many businesses thrive.
However, profits may take time to accumulate -- and even then may not be significant enough to satisfactorily execute the type of scaling that you are aiming for. In such a situation, applying for a bank loan is quite beneficial. Bank loans provide reliable capital which could be enough to scale your business in any preferred direction. In addition, it is assumed -- and rightly so, in most cases -- that the net profit of your company following the expansion would be greater than the interest of the business loan.
Cover up shortfall
Businesses can come across moments in time when there is a dip (or reduction) in cash flow. There are a few reasons for this shortfall: it could be something as simple as the delay between sending an invoice and having it paid. While such delays are expected, problematic situations can arise where there is an immediate need for capital or when a previously scheduled payment has been moved to an earlier date.
These situations can easily create some strain on cash flow. In such situations, bank loans can be a saving grace.
Grow the Team
A business inventory can include many resources like infrastructure, machinery, etc., but the most important resource upon which a company is built is human resources. As a part of scaling, you will need to increase your workforce and your current revenue may not be enough to support the growth of the team. In this case, you can take a bank loan to help fill important positions in your company. Increased staffing will likely mean increased efficiency which will, in turn, lead to an increase in revenue.
Covering Taxes
Most successful startups are quite meticulous with their taxes, making sure that they are paid in the full amount and on time. However, founders too, are prone to make mistakes with calculations. If you have missed out on a certain amount then back taxes may have to be paid at a later date. Late payments like this may come with penalties and interest which might be tough to pay off for early-stage startups. In this case, a bank loan will help you cover the gap when paying late taxes.
Increase production
There may be instances where a large (or customized) order has been placed for your product or service. This is a good sign, as it signifies an increase in demand for your offering. However, you might not have the necessary capital at hand to cover the costs of production in time. A bank loan in such a situation will help you cover the cost of production -- and the profit you make from the sale could even be used to help you pay back the bank.
Best Banks for Startup Loans
Wells Fargo
Wells Fargo is one of the leading names in banking and is considered one of the best institutions to go to when looking for loans. They recognize themselves as “America’s leading small business lender” and have lived up to that promise for many years. The loans they offer to businesses are considered to be good for both conventional businesses and startups/small businesses.
Wells Fargo is known to offer robust financial support to small business owners looking to purchase real estate, equipment, and any other fixed assets. It has years of experience in providing loans to small businesses and can get the process completed in the minimum amount of time.
While banks have a reputation of providing large loans which cannot be matched by small businesses, Wells Fargo adjusts their loans so that small businesses can afford them, too.
Live Oak Bank
Live Oak Bank is based out of Wilmington, North Carolina, and does not have a physical branch -- yet in 2020, it was rated as the top SBA lender in the U.S. In that year, they had loaned out a total of $369,181,900 to small businesses.
The bank started with providing loans to veterinary ventures but branched into various industries over the years. Since their establishment, they have provided an estimate of $2 billion to small businesses.
As the bank has no physical location, they use a streamlined electronic process to take in applications for loans. The required documents can be uploaded online and the progress of these loans can be tracked using your online account. Their years of expertise mean they can provide startups with the right kind of loan(s) and process them quickly. too.
Huntington National Bank
Huntington National Bank is located in Columbus, Ohio, and comes in second on the list of top small business lenders in the U.S. While headquartered in Ohio, they have physical branches in most of the Midwest, including Illinois, Indiana, Kentucky, Michigan, Pennsylvania, West Virginia, and Wisconsin.
Huntington Bank provides small businesses with many options for business loans like SBA 504 loans, SBA Express loans, term loans, real estate loans, etc. Huntington has multiple options available which can help founders through most of the stages of their startup.
TD Bank
TD Bank is located on the Eastern Coast of the United States and is a primary source of small business loans on that side of the country. It provides three types of SBA loans: SBA 7, SBA 504, and SBA Express loans. They have done right by many small businesses and have provided SBA 7 loans worth $46,564,600 to 191 businesses.
Unfortunately, they do not have an online application system and all loan-based business with them must be conducted in person.
Citations
The Best Time To Use Loans To Start Or Grow Your Startup
The Pros and Cons of Startup Business Loans
The 10 Best Banks for Small Business Loans in 2021
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