Funding & Exits — Chapter 11: Commercial Banking
By: Tom Mohr
Tags: Funding, Startup, Finance, Growth, Tech

Now available in ebook + paperback

“Funding & Exits is the definitive guide that I recommend every one of my portfolio companies’ management teams read and internalize” — Bruce Cleveland, Partner, Wildcat Venture Partners

Your commercial banking relationship is important to your financial health. Any business bank provides critical financial infrastructure: your bank accounts, credit card services, bill pay solutions, lock boxes, lending options, cash management options and more. But in the best banking relationships, your banker becomes a valued strategic business partner, helping you optimize interest rates, lending and investment decisions at every step of the journey.

For the very early stage company, the banking relationship is simple. There’s a checking account, an online banking tool, and credit card services. Once you’ve hit Minimum Viable Repeatability, where you have a high six-figure or low seven-figure annual revenue run rate and have raised an A round, it often becomes possible to secure a small ($1M or so) term loan or an asset-backed loan to extend cash runway, and to tap into bill pay and lockbox services. Scale further, and the loans get bigger. Now you may have access to a senior banker, who can advise on a more diverse set of lending options, where to park excess cash, how to structure your cash accounts, how to optimize foreign exchange variations and so forth. Similarly, the tools and services diversify.

Eventually, as you approach Minimum Viable Expansion and Minimum Viable IPO Path, private equity becomes an exit option, and mezzanine lending solutions open up; global payments and cash management become mission critical; and tools for continuous analysis become core to your financial infrastructure. Eventually, when you become a public company, your banking relationship will be highly sophisticated and global. Your lending options will widen further. Big nine-figure loans organized by banking syndicates become possible. You may also choose to issue corporate bonds — debt instruments of at least a 1 year duration. You will likely have a team of bankers dedicated to you full time.

There are four key components of a strategic banking relationship:

Lending

Risk and investment management

Treasury management

Tools and information services

Let’s go through each.

Lending

Debt is an important financing option. Whereas taking on new equity investments dilutes existing investors, debt enables you to bring on the cash without much or any dilution. But of course, it comes at a cost. A commercial bank’s lending business model requires a very low default rate in return for low-interest rates. Unlike venture debt and equity investment, the risk profile must be very low for the model to be viable. To achieve this, banks require downside protection. Debt sits above equity in liquidation preference, so that’s the first level of protection. But most banks also require collateral and covenants in the lending agreement that specify benchmarks a company must hit to continue to have access to the cash. If the company falls short of these covenants, the bank gains the right to sweep the company’s account or liquidate assets to reclaim its cash. Though most banks will work with a company on a workout plan, no CEO wants to be in such a situation.

So debt has risks. You can take on too much, or you can take it on before your company is ready to leverage it properly. There are basic “accounting 101” ratios, such as the debt to equity ratio, the current ratio, and the quick ratio, which can guide decision making — but the basic idea is: before you take any loan, make sure you are very confident you can pay it back.

Commercial banks provide term loans, asset-backed loans and hybrids. A term loan is a loan for a specific amount and term. An asset-backed loan is a loan that is directly tied to accounts receivable, or to inventory. A hybrid loan is specifically designed for recurring revenue models and is tied to revenue run rate.

Regardless of the type of loan you may seek, there are some basic questions you should ask:

How burdensome is the due diligence and approval process?

What covenants, if any, are required? Are there specific revenue thresholds that must be maintained, or a VC approved financial plan that must be met?

What is the consequence of a covenant breach?

What is the bank’s reputation working with companies who have experienced a covenant breach? Any references to company CEOs?

What is the maximum loan amount available? Is this consistent with company needs?

What are the loan repayment terms?

Is there an interest-only payment period? How long?

Can you re-borrow principal that has previously been paid?

Is VC sponsorship required?

Does the bank take warrants as part of the loan? What number of warrants?

What early payback fees are required? Are these reasonable?

Any other fees?

How experienced is the banker you will be assigned?

Shop around. At any point in time, one bank or another may be ready to adopt a more aggressive lending posture. You can only discover these favorable terms by shopping multiple banks at the same time.

Banks that have a track record of working closely and favorably with tech startups on lending terms include:

Silicon Valley Bank

Square One Bank

First Republic Bank

Bridge Bank

City National Bank

Comerica

East West Bank

Wells Fargo

A startup that has recently raised an A round is in a good position to line up a term loan. Banks like seeing recent equity investment in the company. As a rule of thumb, you can expect the amount of the term loan to be similar to the amount of the largest new VC’s investment in the latest round, or roughly 50% of the total round size. Banks figure that a new VC is likely to invest at least one more time, meaning the bank has meaningful downside protection for 12–18 months. Even with a “covenant lite” loan, the bank will ensure downside protection in the case of a company whose current equity investors have lost confidence. To protect themselves, banks hold a senior lien to all the assets of the company, with the possible exception of intellectual property.

If you choose to pursue a term loan, be sure its terms provide you the capacity to use the cash after all VC funding is exhausted. It makes no sense to take out a loan that you can’t use when you need it. Banks often use term loans in no small part to entice CEOs to bank with them. For post A round companies with a healthy balance sheet, a $2M term loan payable over three years would not be unusual. Term loans feature a specified repayment schedule, and carry a fixed or floating interest rate. A borrowing company may benefit from an interest-only payment period of up to a year, followed by two to three years of monthly payments that include principal and interest. Banks that provide term loans to early stage technology companies usually protect themselves with covenants (such as a “Material Adverse Change” clause) requiring certain financial performance thresholds to be met to avoid default.

Banks that serve the technology sector understand that there is both risk and reward in serving startups. They understand that the bank that gets in early and provides strong early support to a company and its CEO might find itself the banker of choice for the next Salesforce or Facebook. Some banks, such as Silicon Valley Bank and Bridge Bank, have a history of company-favorable terms on term loans — including “covenant lite” terms. These banks have built strong relationships with the venture capital community, and depend on VCs to protect their interests when a company falls into difficulty.

An AR line of credit provides roughly 1–2 months of extra runway, because it is advance on the current accounts receivable of your business. It’s not unusual for a company to secure both a term loan and an AR line. In accounts receivable financing, the bank assesses the company’s receivables — money owed by customers — and agrees to provide financing equivalent to a percentage of the average receivables amount (usually in the range of 75% to 80%, depending on receivables quality).

Over the past few years, a new hybrid loan type has emerged. For companies with recurring revenue models, loans may be anchored to recurring revenue assumptions as validated by the customer renewal rate.

Exotic new loan variations will likely emerge over time. For instance, banks are actively evaluating whether to offer loans to companies buying multi-year compute capacity from cloud vendors. If the volume discount the company achieves is big enough, it can make sense for a company to take out a loan for the up front cash purchase, and then pay the loan off over time — yielding an arbitrage advantage vs. pay-as-you-go (as long as the compute capacity is needed and used).

Innovation in lending practices and products will be continuous: another reason to maintain a strong relationship with a highly experienced and committed banker.

The moment you take a loan from the bank, you begin a relationship. The relationship will remain healthy if and only if it is founded on transparency and trust. If you are straightforward about the financial performance of your business, connect regularly with your banker to provide complete and accurate updates and seek help and counsel when challenges arise, you’ll turn your banker into a strong ally. The best banks understand that any tech startup can veer into the ditch on occasion. If you are forthright about the facts and collaborative in seeking ways to get back on the road, such banks will bend over backward to find workable, mutually acceptable solutions.

Risk and Investment Management

As you scale, you must manage risk and make smart investment choices. One risk factor is interest rates. Does your loan feature a floating interest rate in a rising rate environment? It might be time to switch to a fixed interest rate loan. Another risk factor is foreign exchange. How do you manage inter-country cash transfers and hedge bets so as to minimize foreign exchange risk?

Then there are your cash investment decisions. Are you holding a material amount of cash in a non-interest bearing account? It might be time to buy short-term CDs, or at least to throw your money into a money market fund.

Foreign exchange rates and interest rates don’t stay stable. Both on the lending side and the cash management side, you need to have a banker that helps you optimize your cash yield.

Treasury Management

To efficiently manage incoming cash, you may ask your banker for a lockbox service. Checks from customers are sent to the lockbox and processed there. Cash might then move through a waterfall structure — flowing first into a consolidated checking account until you reach a certain cash balance threshold, with surplus funds flowing into an interest bearing account or a money market fund. As you scale, you might have multiple points of entry for your incoming cash. All are brought together through consolidation accounts and then follows the waterfall path to serve cash uses and optimize yield.

And on the disbursement side, you may decide to build a disbursement architecture for cash management and then use bill pay tools to execute payments. Once again, a good banker will help you architect these cash flows consistent with your needs and stage of business.

Tools and Information Services

Banks provide tools to support your business. These tools are critical components of your company’s finance and accounting infrastructure. At its most basic level, your online banking tool should provide you full visibility into your current cash balances, account by account. It should also provide the status, payment history and terms of all loans.

As you scale, bank tools should be able to provide a global view of your cash position — by country and currency. Bank tools have become increasingly mobile-friendly, and for the leading banks, they are analytically robust.

Summary

Most startup CEOs underestimate the significance of a good banking relationship and a competent, committed banker. Take the time to find the right bank, find the right banker, and then invest into the relationship. Never forget, the relationship is two-way. You expect the banker to provide you with helpful guidance on how to fully leverage the bank’s capabilities. In return, the banker expects you to be forthcoming and transparent about the state of your business, in good times and bad. When a CEO is transparent during difficult times, the best banks will bend over backwards to support the company. But where that transparency is lacking, banks will take steps to protect themselves — steps that may compromise the company’s long term prospects. In short, do the right thing. Integrity wins.