This blog post is based on a conversation we had with Reza Sabahi for the Fundraising Radio podcast. Reza Sabahi is the managing director at Wells Fargo Capital finance (https://wellsfargocapitalfinance.com) , which is one of the specialized lending lines of businesses at Wells Fargo. It is a business to business commercial loan portfolio. Reza’s department exclusively provides finance to technology companies (primarily software companies in North America and Western Europe). In his role Reza oversees a team that manages direct credit exposure to a variety of different technology companies.
Reza on what leveraged Buyout (LBO) is:
According to Reza an LBO refers to making an acquisition of an entity or entities using a lot of debt. He advises startup founders that an LBO is an alternative option for a liquidity event.
Difference between loan- and revenue based financing:
Reza notes that it is difficult for a startup to obtain credit from a bank. It is easier now because technology has become such a big part of our lives that banks are more willing to provide loans to startups or early stage technology companies. Additionally, Reza pontificates that typically non bank lenders offer revenue based financing. Revenue based financing works by lenders providing debt structured around the revenues of the startup which means that a lender will give a company a percentage of their revenues whether it is one or two times mrr. Unlike pure revenue based financing where it is a revolving line of credit, so that companies only have access to whatever their revenue formula is, banks like Wells Fargo are willing to provide term financing. Meaning that day one startups may have access to a much larger source of capital, without the same burdensome requirements to pay down and borrow. Obviously that is case by case and depends on the performance of the business.
What other factors play a role in deciding if a traditional bank will give financing to a startup:
Reza shares that the fundamentals for extending credit to any company are going to be the same: banks want to understand the business, the billing practices, services the business provides, and the management of it. However, technology companies are unique and some of the things they look for when it comes to tech companies are: the quality of the revenue, the churn of the business, gross profit, cash flow conversion, the cost structure, enterprise value, total addressable market (TAM), and what the source of funds are going to be used for.
The requirements for startups to get capital from a bank:
Reza says that the first thing an entrepreneur needs to be armed with is a very strong understanding of their own business. He also states that founders will also need a very detailed and achievable forecast as well as an ability to explain that forecast to someone who might not be familiar with the industry. For most bank loans you will also need 2-3 years of revenue history. Although, banks require revenue that does not necessarily mean that they need a company to show profit, in order to extend credit. Another thing that you don’t necessarily need to get credit from a bank is near-term cash flow. Of course you need to be able to articulate why your company is not generating cash flow and explain at what point you might be.
In summary, what you need in order to secure financing from a bank is to know your business, have revenues, have a plan, and have conviction for whatever your plan is.
Why startups don’t need cash flow in order to secure a loan from a bank :
Most technology startups do not need to generate near-term free cash flow in order to get financing from a bank because sometimes there is much demand for the product or service of a company that it is more accretive from a valuation perspective to invest cash flow from operations into sales and marketing and product development. However, startups do have to have a plan to generate cash flow at some point in the future.
What amount revenue is required to obtain credit from a bank:
According to Reza most banks lenders will want to see a technology company with at least 2 million in annualized recurring revenue. Now that does not necessarily mean that you need 2 million of trailing 12 month revenue. If you are a high growth startup and if your mrr is growing aggressively, there are lenders that would look at your most current quarter or month and annualize that figure. Once a technology company gets to 7-10 million in recurring revenue there are a lot of good options for financing.
Pros and Cons of receiving financing from a bank:
Reza cautions that most banks when dealing with the companies that have low revenue are going to require a personal guarantee from the founder which means that if the company is unable to pay its obligations and repay the loan, the bank will in most cases try and go after the founder of the company, including going after their personal assets. However, that is generally not going to be a likely outcome because if the lender is doing their diligence they should not find themselves in that situation. Moreover, bank loans and financing comes with rules and restrictions that may not come with equity investments. For example, even if you get a small loan you're going to have to provide the bank some reporting. It is not uncommon to be required to provide monthly reporting, quarterly reporting, or annual reporting. Additionally, most bank loans come with loan covenants. The term covenant is just a fancy legal way that means you are agreeing to do or not do certain things. Some common loan covenants require you to generate a certain amount of revenue or that your leverage does not get too high. In terms of pros from receiving financing from a bank is that you generally don’t have to give up equity.
Call to action:
Reza’s call to action is to urge entrepreneurs to have a solid understanding of the finances of their business. Know it so well that you can articulate it easily and effortlessly.
He also advises startup founders that going the equity route is not the only option for raising money.
This blog post was written by Luis Bravo.