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3 Realistic Ways to Finance a Software as a Service Startup

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Software as a service startups are popping up everywhere these days, and for good reason.  The monthly recurring revenue business model is certainly desirable because it is predictable and profitable.  The problem with a successful software as a service company becomes financing growth.  Generally with software as a service there is no upfront, one time cost to get started.  Instead, many times a company will offer the first few months for free as an incentive to get a customer to try the service.  The problem is that in general most of the costs for the company are incurred when they sign up a new customer.  For example, it may cost you $100 to acquire a customer who then pays $20 a month for your service.  This is a great business if you can keep the average customer for longer than 5 months, but it causes some real cash flow issues.  Each time you sign up a new customer, you need to come up with $80 initially to fund the difference between the acquisition costs and the first month’s revenue.  So how do you finance a business like this?  At some point you will be able to raise investment, but probably not right away.  You need to show growth and sales first.  So here are 3 realistic ways to fund this type of startup:

1.  Microloans – Traditional banks are scared of software, they are scared of this type of recurring revenue business model in the early days of the business because every time you grow you need more cash.  That scares the traditional bank, but there is another option.  The SBA has a program called the Microloan Program.  There are SBA microlenders all around the country who work to fill a lending gap.  They lend where traditional banks do not.  You won’t be able to run forever on a microloan, but it may help you get closer to securing that large investment or line of credit from the bank.  Microloans are typically between $1,000 and $50,000.  Here is a listing of all the SBA Microlenders in the United States.

2.  Credit Cards – In a software as a service business you will always need additional funding if you want to grow.  There is no magic bullet.  Even if you raise some angel investment you will need to come back for more time and time again if you want to grow.  A majority of your costs are up front.  Over the long term each new customer will be profitable, but that breakeven point might not be for 6 months or longer. Sometimes this problem may drive you to fund your growth with credit cards.  This is not ideal, but it can work.  Just like a microloan, a credit card won’t solve all of your financing problems, but it can help you kick the can down the road.  The problem is, if you go to an investor and you have very little in sales, you are going to have to give up a huge percentage of ownership.  You need to find ways to increase your sales so that you can demand a higher valuation when it comes time to meet with investors.  Yes it is risky to get yourself too deep in debt growing the business and then find out you can’t secure an investor, but generally you will be able to find investment for a growing software as a service business, the only question is the valuation.  How much of the business will you give away.

3.  Alternative Financing – Lastly, there are some interesting new ways to finance businesses that charge their customers via PayPal or credit cards.  New alternative lenders are actually taking your PayPal data or your credit card/bank account data to determine how much they are willing to lend to you.  There are two examples of this type of financing.  Kabbage.com uses your PayPal data, social network data, and Amazon or eBay seller data to determine your credit-worthiness and how much you are able to borrow.  Similarly, OnDeck Capital uses your cash flow data from your bank account to determine if they are willing to lend and how much they are willing to lend.  Then they actually pull small payments back from you on a daily basis.  They realized that it could be hard to come up with a 1 time monthly payment for your loan, so they pull on a more regular basis.  This reduces their risk and a lender.  Now both Kabbage and OnDeck come at a price.  This is certainly not the cheapest way to fund your business, but it can help you grow without giving away the entire company to an investor.

All 3 options here are a bit more realistic than walking into your local bank and asking for a $100,000 line of credit to help grow the business.  That is very rare for a software company and even more rare for a startup.  So consider these financing options as stepping stones until you get to that $500,000 in annual recurring sales.  At that point you will be able to secure an investor without giving away all of your equity.  Good luck!

The Sure-Fire Way to Get a Loan for Your Small Business

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At the end of the day it all comes down to one question.  Any potential small business lender is going to ask one ultimate question that will decide the fate of your loan application.  That question is: “will we get our money back?”  There are 3 ways that a small business lender can recoup funds from a borrower, and if you can prove that you can repay the loan from at least 1 of these 3 sources, you will likely get approved for a loan.

1.  Cash Flow – The best way to secure a loan is to convince the bank that your business will produce enough positive cash flow to repay the loan.  In order to do this you are going to need to create a set of pro forma financial statements with reasonable sales and expense assumptions.  You will also need to show that you can repay the loan based on past financial statements.  If you lost $300,000 last year, you are probably going to have a hard time convincing the loan committee to approve a loan.

2.  Collateral – If the business fails, and can’t pay back the loan from cash flow, then the lender is going to come after your assets.  If you have assets that can be legitimately valued at more than your loan amount, then you are much more likely to be approved for a loan.  Different types of collateral have different levels of value in the eyes of a banker.  For example, your inventory may only be worth half of what you value it at to the bank because the bank may not know how or where to sell the inventory.  A vehicle is stronger collateral because it can be easily sold, but may not hold its value over time.  Finally, a building tends to be strongest form of collateral because it has a longer useful life, and should hold its value longer than other forms of collateral.

3.  Co-Signer – Sometimes your past financials, future financial projections, and the value of your collateral won’t be enough to make a banker feel comfortable with your loan request, so you need to bring a strong co-signer to the table.  Lenders want to see a co-signer with a strong credit score because that means they have something to lose if they don’t pay back the loan.  A co-signer with assets and a strong credit score can really solidify your loan application.

Bankers really aren’t that hard to figure out.  At the end of the day they just want their money to come back with a little bit of interest.  Bankers really don’t want to have to come after your collateral or your co-signer, so your cash flow projections are going to be vital to your success.  

Top 3 Reasons Banks Will Deny Your Small Business Loan Request

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Let’s face it, these days there are hundreds of excuses that a bank could come up with to deny your loan request.  I manage a small business microloan program in Indianapolis that tends to make loans to small businesses that have already been denied by the bank.  I have heard many reasons, but there are 3 things that come up again and again.

1.  Less than 2 Full Years in Business – The banks must use data to show that after a business makes it past year 2 their chance of survival increases substantially, because almost every traditional bank I know will not lend to a business less than 2 years old.  Something to keep in mind here is that banks determine how long you have been in business by your tax returns.  So you must file your business tax return in the first year even if you don’t have much to show yet.

2.  Bad Personal Credit – Unfortunately for many business owners, your personal credit history impacts the ability to get credit as a small business.  In the early years of a small business the financial situation of the business and the business owner go hand in hand.  It takes a lot of time, and a lot of paying your bills on time to establish credit for the business that is looked at separately from your personal credit.  If you have bad credit, the best thing you can do is to use credit and pay your bills on time.  Sometimes business owners with past credit problems just tear up their credit cards.  Unfortunately you can’t increase your credit score if you never use credit.  Responsible and wise use of credit will improve your score over time, and help your small business secure bank financing.

3.  Scary Industry – It is very common for banks to have internal policies that keep them from making any loans in certain industries.  Restaurants are a good example.  Banks avoid funding new restaurants like the plague because so many fail.  I think the reason that so many restaurants and coffee shops fail is because everyone thinks they can own a restaurant.  They think, “Hey I know how to cook, I bet we could have a successful restaurant.”  What these hopeful entrepreneurs fail to realize is that the food has very little to do with your chances for success.  Just take McDonalds for example, they sell more hamburgers than any other company in the world, yet I can count 100 places to get a better burger just off the top of my head.  There are certain industries like restaurants and sometimes construction that just keep the banks running in the other direction.

These are just a few of the reasons that you will get a quick no from the bank, as I mentioned there are many more, as there seems to be an endless supply of reasons for the big banks to deny your small business loan request.

How Much Money Do You Really Need for a Startup

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I manage a microloan program at a non profit.  We make microloans to small businesses and startups for up to $50,000.  One of the biggest problems I see on a daily basis is that entrepreneurs ask for too much money for their startup.  I think it is human nature to try to be conservative, and ask for more funding than you actually need in order to give yourself some cushion, but when you really sit down and run some financial projections you may find that it actually requires very little to start a company these days.

There are 3 points that I want you to consider when you are developing your startup cost projections:

1.  You Can Start Slow – I think it is very important to note that you don’t need to start your business on day 1 at 100% capacity.  For example, you may have a great recipe for a hamburger, so you decide you want to open a burger shop.  The problem is that your startup costs for a new restaurant run up toward $200k.  How do you know that people other than your family and friends will like your signature recipe?  Before you invest $200k into a full blown restaurant, you should consider some other simple ways to test your product. Maybe you can set up shop at a fair or a conference, or maybe you could invest one tenth of the cost to get a food truck up and running first. Check out our food truck template for more information on starting a food truck business.

2.  Revenue Does Not Start on Day 1 – Believe it or not, you won’t get rich on day one.  You might make a killing on your Grand Opening, but you probably put in a few months of work before your Grand Opening.  When you think about your startup costs you need to remember that you might need to pay a few months of the following expenses before revenue starts to kick in:

  • Rent
  • Wages
  • Insurance
  • Advertising
  • Lawyer Fees
Keep this in mind as you develop your projections.

3.  Microlenders Prefer Smaller Loan Requests – Big banks prefer big loans, but microlenders are typically given an incentive to keep their average loan size as small as possible.  So it is OK to request a $5,000 loan.  You can start your business by testing the market while investing the least amount of time and resources as possible.  Here is a link to a list of all of the SBA Microlenders in the US.  Many of these microlenders will actually try to help you borrow the least amount of funding as possible to help you get to the next step.

In almost every case, you can get started with less funding than you expected.  If you have never attempted to start your own business simply because you don’t have the funding, take another hard look at how much you really need to get started.  Start small, and grow big!

You can create a full set of 3 year financial projections on ProjectionHub today.

Why Your Loan Application Should Only Fund One Project

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Sometimes loan applicants will apply for a loan to fund multiple projects, equipment, events, etc.  This is difficult for a loan committee to approve because it is hard to determine the impact of the loan.  It is easier to look at the impact of one new salesperson, one piece of equipment, or one booth at an industry conference has on the bottom line, than it is if you ask for a loan to fund several items.

Keep this simple tip in mind as you look to apply for a loan.

3 Financial Ratios Your Banker Will Look at in a Loan Application

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image for banker ratios blog postNew entrepreneurs, or business owners who have never dealt with a lending institution before often think that securing a business loan is as easy as demonstrating that you have generated a profit in the past, and your business plan “shows” that you will increase your profits if you get a loan.  Unfortunately, it is not that easy.  Maybe it should be that easy, but in reality the bank is going to look at a number of other key ratios.  Although ratios don’t make sense to the average entrepreneur, the bank will rely heavily on just 3 ratios to get a good picture of your business, so it is important for you to understand how to calculate them and more importantly what they mean and how you can improve. So here are the 3 important ratios that you must understand:

  1. Leverage Ratio – Your leverage ratio is calculated by dividing your total business liabilities by total business equity.  Some suggest that a leverage ratio over 4 to 1 would significantly reduce your chances of securing a traditional bank loan.  The basic idea is that your lender doesn’t want you to simply borrow in order to grow the business.  You need to put something in as well.  So how do you improve your leverage ratio?  Pay off your debts and your leverage ratio will come down, or simply increase your cash balance without borrowing.
  2. Loan to Value Ratio – Your loan to value ratio is calculated by the total dollar amount of the loan divided by the appraised value of the collateral. Most lenders will require the appraised value of your collateral to be higher than the loan amount.  The lender is looking at this ratio to see how much breathing room they have.  If the business is to default on the loan and the bank ends up with the collateral, the bank wants to make sure they can sell the collateral for a value high enough to recover the entire balance of the loan.  You should simply provide the bank with collateral that is appraised for more than the amount of the loan.
  3. Debt Service Coverage Ratio – This final ratio is a bit more complex, but still incredibly important when applying for a loan.  You can calculate your debt service coverage ratio by dividing your annual net income by your annual debt service.  Debt service is a fancy way of saying your loan payments.  Again this is simply a way for the bank to determine how much breathing room they have.  This ratio tells the lender how many times you could make the loan payment with your net income.  If you could make the loan payment 10 times with your net income each year, you have plenty of breathing room.  If you can only make the loan payments 1.25 times per year, the bank is going to be nervous that if there is any negative downtrend with your business, you won’t be able to make your loan payment.  This is simply a ratio that you should be aware of, so that you don’t request a loan that is larger than you can handle. 

If you have a good handle and understanding of these three ratios, you will be able to go into the bank with confidence that your loan request is reasonable based on industry standard ratios.  Once you create a set of pro forma financial statements based on your proposed loan, go through and calculate these ratios, and you will be far ahead of the average business owner.  Good luck!

Photo by RODNAE Productions from Pexels

ProjectionHub Picks 5 Microlenders to Help Improve Loan Application Process

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In early June 2012 the ProjectionHub team announced an opportunity for 3 microlenders from around the country to apply and win the chance to create a custom financial projection tool for their loan applicants to create their financial projections.  There was such a great response that the team felt the need to choose 5 microlending organizations.  The following organizations have been selected as winners:

  1. alt.Consulting
  2. CDC Small Business Finance
  3. Iowa Microloan
  4. Southwest Initiative Foundation
  5. Community Development Resources

These organizations have literally made billions of dollars in loans to small businesses.

Co-Founder of ProjectionHub, Adam Hoeksema, said, “It is an incredible honor to work with such prestigious organizations.  He hope to learn from these experts and ultimately help their loan applicants create more accurate and realistic financial projections.”

Over the next several weeks the ProjectionHub team will work with these lenders to create a custom version of the pro forma financial tool specifically to meet the needs of each organization and their loan applicants.  The tool will be a more user friendly alternative to the complicated Excel spreadsheet templates that most business users utilize to generate a set of projections.

Some have described the tool as an up and coming TurboTax for financial projections.

About ProjectionHub:  ProjectionHub is a web based tool that help business owners create financial projections without a PhD in spreadsheet modeling.

Is your Startup 98.82% Likely to Succeed? If Not, No Loan for You

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recently reported that delinquencies for business loans are now down to 1.18%.  In my opinion, this is truly incredible!  Only 1% of businesses with loans from banks fail to make their loan payments on time.  This means that you must convince your lender that you are 99% likely to make your loan payments.

Based on this data, it is no surprise that startups and early stage businesses have a nearly impossible time securing loans from banks.  When you look at the data for small businesses, you will find that there is a significant percentage of businesses that will cease to exist in 5 years.  Let’s say 25% of the small businesses with less than $1 million in annual sales will be out of business in 5 years.  That means that banks are going to be incredibly unlikely to lend to these small businesses because they need to feel 99% confident that you will still be around in 5 years.

That rules out startups and early stage small businesses in technology industries like software, mobile computing, alternative energy etc because technology moves so incredibly fast that 5 years is a lifetime.

Unfortunately for small business owners banks can be selective.  There are still plenty of credit-worthy, established businesses that will take loans.  The banks don’t need to lend to small businesses in order to make a profit right now.  In fact, the top 10 banks in the United States only approve approximately 10% of loan applications.

If you are a startup, what do you do?

I believe there are still some great options.  There are 3 places I encourage you to look for a loan:

  1. Lendio – Matches you with lenders that best fit your needs and stage of business
  2. On Deck Capital – Unique way of lending to “Main Street” businesses.  Lends even if your credit score is low
  3. Prosper – A peer-to-peer lender where you may be able to build up to a loan capacity of $25,000.

Of course these options will have higher interest rates than your traditional bank, but if you are able to utilize other funding sources during the early stages of your business, you may be able to reach a point in time where you can actually convince your local banker that you are 98.82% likely to pay them back, and pay them on time.

Have you been successful finding other sources of funding since the banks don’t lend?  If so, leave us a comment, and share with other entrepreneurs who are looking to grow and expand.

Software Development Loans – Impossible to Find?

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Red No Circle Clip ArtBanks don’t give loans for software development, it is simply too speculative.  If the software has not been developed yet how do you know whether anyone will be willing to pay for your product?  How do you know what a potential customer is willing to pay?  How does the lender even know if you actually know how to program?  There are so many hard questions to answer that most banks will simply avoid providing loans for software development altogether.

If you are determined to get a loan to develop software there are a few ways you might be able to convince a bank to lend to you.

1.  Get a Signed Contract – If you have a signed contract from a customer this will answer a couple key questions.  Now the lender knows that someone is willing to a buy a product, and they know how much they are willing to pay for it.  There is still a major question though.  How can you prove to the lender that you and your team can successfully overcome the technical challenges and fulfill the contract?

2.  Demonstrate a Track Record of Success – Have you completed other software projects?  Have you worked with this specific client before?  If you can demonstrate that you have been doing this kind of work for 10 years and you have worked with this client on several similar projects, then you might be able to convince the lender that your past success will guarantee your future success on this project.

3.  Generate Sufficient Cash Flow from Current Business – If your business is currently profitable and providing sufficient cash flow to cover your loan payments you can probably secure a loan to expand your current business.  The bank will want you to use the loan to expand your current, stable business, but if you can use the loan to increase cash flow from your current business, you can then take that excess cash and invest it into your software development project.

If you can get a signed contract from a client you have worked with in the past, or you can generate sufficient cash flow from your current business, you might actually be able to secure a loan for software development.  If not, then you should probably start looking for investors who have an appetite for risk.

About the Author:  Adam Hoeksema is the Co-Founder of ProjectionHub.  ProjectionHub is a web application that helps entrepreneurs create financial projections without the need for a PhD in spreadsheet modeling.

Year 2020: Small Business Lending Predictions

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Small Business Lending in 2020

By Adam Hoeksema

The financial services industry is ripe for disruption on a number of fronts.  In my opinion, small business lending is one of the most likely sectors to see a complete transformation.  I have listed 5 predictions that I believe will impact small business lending by 2020.

1.  Personal Credit Scores Will Have LITTLE to do With Small Business Loan Approval – Currently, lenders look at the personal credit score of the business owner as a major factor in the creditworthiness of the business.  Clearly, the personal credit score has no bearing on the quality of your business model, marketing plan, or profit margins.  In the past, banks have had no other option because other (more relevant) data was not readily available.

New data is becoming available.  For instance, Intuit can provide data to banks including:

  • Accounting Data through Quickbooks
  • Industry Data through Quickbooks
  • Personal Budget and Financial Data through Mint.com
  • Personal and Business Tax Data through TurboTax

If a bank can access this data for individual borrowers and compare to the aggregate numbers provided by Intuit, the personal credit score starts to become the least relevant piece of data.

2.  Peer to Peer Lending and Crowdfunding will Dominate the Traditional Bank – Major platforms like Prosper.com, LendingClub.com, and Kickstarter have such an incredible advantage over traditional banks when it comes to small business lending.  A bank may not even be able to make a profit on a loan that is $50,000 or less because of the incredible overhead costs.  Web-based platforms don’t need a physical branch location in every city to get distribution of their loan products.  Without that overhead these online lenders will be able to start lending profitably at a much lower dollar amount.  Right now a borrower might only be able to borrow up to $30,000 on these platforms, but by 2020 I am certain these lenders will find a way to increase their loan capacity in order to eat away market share from the traditional bank.

Online lending is simply more efficient, it is only a matter of time before online lenders will do to the banks what Amazon.com is doing to retailers.

3.  Cash Flow Will Still be King –  On Deck Capital is already proving this to be true.  On Deck looks for businesses with a large number of smaller clients.  For example, a grocery store has a large, diverse customer base that is consistent.  On Deck can look at their credit card deposit data and feel very comfortable lending based on the fact that they are generating cash, and it is protected from a major shortfall because of the diverse customer base.

4.  Factoring Receivables Will Become Incredibly Efficient For the Small Business – New web based technologies and data will make it much easier to factor smaller invoices.  The Receivables Exchange is already proving that it is possible to factor receivables much more efficiently.  In the past a business owner might give up 10% of their sale for cash today instead of waiting 45 days to get paid.  If you annualize this interest rate, you will see that it is a terrible way to finance a business.  The Receivables Exchange is ultimately much cheaper because it diversifies risk for everyone.  I might purchase a small portion of your invoice along with 100 other people.  You end up paying a small percentage of the invoice in exchange for getting your cash up front.

Right now, the invoices must be bundled in $10,000 increments at minimum, but I believe this type of system will ultimately allow you to sell very small invoices which will reduce your need for a line of credit from the bank.

5.  Two Years in Business Won’t Matter Anymore – Business moves fast these days, and it is only going to accelerate.  In 2 years Groupon went from nothing to hundreds of millions in sales.  In less than 2 years Instagram was launched and purchased for $1 Billion.  Not every business will move that fast in 2020, but I believe that banks will have the data and technology needed to analyze the creditworthiness of a loan applicant without considering whether or not they have been in business for 2 years.

If the business is growing, and can afford the loan, 2 years of operating history should not be required.

I am sure I am wrong on some of these points, but in my opinion the next 5 to 10 years is going to be a painful one for the traditional small business lender.  Small businesses will find other sources of funding that are becoming available at an accelerating pace.  I think most business owners are incredibly frustrated with their current bank, and would leave them in a minute if there was a better alternative.  Once they leave, it will be nearly impossible to get them back.

I would love to hear your thoughts on the subject.  What predictions do you have?