10 E101 W2 The role of debt financing in startups

If you look at the real startup stories apple google and so on none of these companies started with debt financing why is that well actually the risk relation the return relationship was not really good for banks i’d like to talk about that a little further in this chapter so if you go back in the days of adam smith he once said banks should expand the credit

Policies since the only additional effort is the administrative one during his days that might have been right if you look at the bankruptcy of today their perspective is there are no profit sharing schemes for us if you’re successful why should we invest in your business then if you look at what banks are doing they give money to customers they get a interest

Rate so think about the bankruptcy rate of companies of tech companies let’s say 50 percent if you have a 50 bankruptcy risk in an industry and if you give money to that industry what is your risk premium of the interest actually with every second credit you give you have to earn the other credit means you have to have a hundred percent interest rate actually

No startup wants a hundred percent interest rate and and then no bank can i can ask for a hundred percent interest rate this is why actually this this banking business is not made for that kind of risk return relationship if you as an equity investor have a 10 share in the business and the one business is going through the skies and you made a make a hundred

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Million and the other business is going bankrupt you invested a million or you even invested 10 no worries because you end up with 90 million and that’s the difference between banks and equity capitalists and in the banking business giving a credit normally is being done in that scheme as a client you have relationship manager this is the guy if you step into

A bank who says hello to you and talks to you if you say i i’d like to obtain a credit from you he puts together all the material and or you help him putting together all the material and it gives all those relevant documents to a credit analyst actually a guy who doesn’t know you and this credit analyst is basically doing his decision based on four criteria

Financial conditions in a startup they are not really good account management you might not have it because you just started marketing competition might be good for you management competence actually there are better companies out there sure those established companies they have the capabilities you don’t so if you look at their criteria and the question if

You can meet the criteria you probably end up with a company risk factor this is what they do which is somewhere over here d plus or f plus or whatever and banks want to serve a b customers they don’t want to serve those and this is why technically banks don’t like to serve startup entrepreneurs even if you can adjust the company risk factor by bringing in

Liabilities your own house or something less if you borrow against your house and your company gets bankrupt you lose your house the bank gets it but banks don’t want to deal with houses they want to deal with money so even this they they hate and in general so to say it is difficult dealing with banks because the risk return relationship you are offering to

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The bank is not feasible for for banking with banking businesses and this is why starters generally do not fulfill the credit conditions of banks and this is why startups normally don’t obtain credits from banks however i’d like to add one thing why is it still very very important for a startup cfo to have a good relationship with your local banker well think

About the bar think about you open a bar you invest into the bar you invest into the drinks and you hope customers will come so what you need for that is working capital how do you calculate your working capital well you think about the number of people who are coming and the amount of time you have to to to have bottles and juice and all sorts of things on

Stock in order to serve that number of people so you need some working capital which you have calculated in your cash flow statement now something very very nice happens more customers come or someone wants to do his birthday party in your bar because it’s such a great bar so you need to have more drinks on stock which also means you have to have more working

Capital how do you meet the demand of more working capital actually ask your local bank that’s the only way you can do that because your local bank if you if you have an online bank and ask them i need a higher credit line they have they sit anywhere in the world and they decide on without looking at you the local bank maybe the banker knows you and maybe you

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Can say okay i am willing to expand your credit line because i love to see your bar being so successful so having a good relationship to your local banker has advantages of the possibility of getting more funding in if if it’s necessary especially also when your company develops positively and with a short term funding like the credit line of your bank account

And this is why in general banks do not serve startups with credits with debt financing the only exception is the credit line of your bank account but it’s worth having a local bank and a good relationship with your local banker because in combination of those two that really helps you sometimes to survive with your own business

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10 E101 W2 The role of debt financing in startups By Entrepreneurship 101