According to recent statistics from the American Small Business Administration (SBA), some 28.8-million small businesses account for over 99-percent of startup company’s founded in the United States.
While the majority of entrepreneurs start their company with success in mind, 20-percent of startup ventures fail within the first year of operations. For those that survive year-one, a further 40-percent of businesses fail within the next 2-years. It’s shocking to discover that only 3-percent of all new companies make it into their fifth year, the majority fold due to a catastrophic financing event.
29-percent of startups and established businesses cite their primary cause of failure as a lack of capital, with over 80-percent of entrepreneurs closing their doors within the first 16 to 18-months, due to lack of funding. Another disturbing statistic shows that only 30-percent of all startups ever break even. A further 30-percent continuously bleed capital, forcing the founders to liquidate the company.
Surprisingly, in the face of these glaring statistics, more than 40-percent of business owners think they are knowledgeable about the financing models available to them. Given that financing is such a critical component of founding a startup, why is it that so many entrepreneurs struggle to source the funding they need to succeed?
Startup Funding Problems – Sourcing the Ideal Financing Model
Sourcing funding for a new business idea or existing business is a task that presents a significant challenge. In a survey conducted by the NSBA, 27-percent of entrepreneur’s claim that they were unable to source adequate funding for their business.
The majority of founders choose to seek funding from traditional avenues such as bank loans and credit lines, which include financial vehicles such as credit cards. This course of action is due to many of them failing to secure traditional business loans, due to the aggressive lending requirements issued by banking institutions.
Issues with Securing Loans from Financial Institutions
In 2017, only 23-percent of finance applications met the requirements for loans issued by big banks. Entrepreneurs experience better success in securing funding with other institutional lenders, such as life insurance companies (48.7-percent approval rate,) and savings banks (62.8-percent approval rate.)
Data from The Wells Fargo Small Business Index and the Kauffman Firm indicate the average startup loan is between $10,000 to $80,000. This figure is a stark contrast to the data provided by the SBA, which estimates the average business loan to be in the region of $371,628.
Large banks are hesitant to provide funding to new ventures, and going-concerns, due to high delinquency rates. As of February 2018, 4.7% of all business loans are delinquent. The inability to repay a loan increases risk exposure of the large banks. Therefore, their lending criteria are far more stringent.
Reviewing the criteria for a bank loan shows that the following factors are responsible for such low success rates of securing finance.
No Track Record
Startups lack a successful track record. Therefore, large banks look at the track record and experience of the entrepreneur when weighing their decision to approve a loan.
Similarly, existing companies need to prove a successful track record of business to receive approval for a loan to expand their business. Big banks cite weak management, as well as feeble business planning, as the top reasons for denial of funding.
Lack of Asset Collateral
Large banks demand security in the form of asset collateral to offset the risk of financing a business loan.
However, since most small businesses are generally looking for a loan to fund the purchase of plant and equipment, they lack any assets to offer as collateral. Existing enterprises searching for finance to expand their operations may already have encumbered assets, disqualifying them from using their current holdings as collateral.
Growing Your Business – Problems with Funding Business Expansion
Finding funding isn’t only the number one issue for startups. It’s also a concern for existing companies that want to scale their operations and expand as well. When assessing a company’s financial health, large financial institutions will review the following to determine the risk involved with making the loan.
Cash Flow Issues
A United States bank study shows that 82-percent of companies fail due to cash flow issues. Problems with handling supplier accounts, as well as overdue receivables from clients, cripple the financial health of startups and existing businesses alike.
In a survey of business owners by the SBA, 45-percent of entrepreneurs admit that they did not realize their company has a credit score. Furthermore, 72-percent of business owners have no idea of where to find their credit score.
FICO SBSS scores take 5-factors into account when assessing the credit health of a company;
Credit utilization: This figure accounts for the amount of credit acquired by the company, versus the amount of credit offered to the business. This figure accounts for 30-percent of the total FICO score.
Payment history: Does the business pay its bills on time? This factor accounts for 35-percent of the score. Unfortunately, the majority of business owners are unaware that a single late payment could affect their FICO score, by as much as 100-points.
Credit history: The duration for which a company has borrowed money in the past. This factor accounts for 15-percent of the score.
Credit mix: Utilities, mortgages, and other credit lines, such as credit cards all contribute to the health of the company’s FICO score, making up 10-percent of the final value.
New credit applications: Every time a business applies for credit, the lender will run a credit check on the company. Too many credit checks over a small period will damage the company’s FICO score. This factor accounts for 10-percent of the score.
The Credit Conundrum
Most lenders set their minimum FICO SBSS (Small Business Scoring Service) score at 160. However, startups have no credit history, making it near impossible to secure a traditional business loan from a large banking institution. Data from the SBA show that less than one-third of existing businesses in the United States currently meet this lending criterion.
Solutions to Business Funding Problems
In 2017, 60.7% of all business loans came from alternative financing models. Here are a few examples of other methods entrepreneurs can use to secure the business funding they need.
Nearly 75-percent of all business owners use their finances as a means of funding the company. While this method increases personal financial risk, it alleviates pressure on the company. In 2017, 6-percent of all business loans came from friends and family.
VC and Angel Investors
This financing model ties the company to a private entity. In return for funding, the company must meet financial milestones to secure successive rounds of funding. A survey conducted by DocSend shows that startups met with 58 investors, arranged 40 meetings, and required an average of 12.5 weeks to close the first round of funding.
Crowdfunding and ICO’s
This method of funding is becoming increasingly popular, with companies offering virtual tokens to investors to secure finance. A pre-sale of these tokens allows startups and existing businesses to raise capital from multiple sources. The model is similar to selling stock in a publicly listed company.
Wrapping Up – A Final Word on Finance
In today’s economy, its critical for any business venture, startup or going-concern, to evaluate their need for funding. Never loan more than you can afford to repay. Beware of funding models that offer a moratorium on payments; you may end up paying a colossal amount of interest on the original loan amount.