Banks –  Concerns for Startups  (via Pinsky Law, “Banks“)

Banks are a major source of both short term and long term funding for many conventional companies. Through borrowing, an entrepreneur is able to acquire the funds he needs to operate his business without giving up control of a business.

For startups the principal problem with bank borrowing is that, in addition to charging interest, banks require borrowers to adhere to very strict operating standards to keep the loan in good standing. The pressures of operating in such an environment can outweigh the benefits, particularly for a startup company that may experience difficulty being confined by external restrictions imposed on its changing business models.

Another problem with bank borrowing is that, when making a decision whether to extend a loan to a startup company, banks pay close attention to the company’s financial history and projects and to the management of the business. Since most startup companies rarely have more than a business plan and a budget, qualifying for bank loan is not often possible. Also, banks usually will not lend funds without collateral valued at least the principal of the loan.Many technology startups are not “asset-intensive” businesses, and it is often difficult for even established companies to qualify for a loan, unless they possess highly valued intellectual property protected by patents. Banks typically will also require a personal guarantee of a loan from owners of a startup business, so should the company fail, the bank will seek to collect as much of its loan as possible, and the entrepreneur could lose more than he bargained for.

Investment Banks (via Pinsky Law, “Investment Bankers“)

Investment bankers are not bankers. Nor do they invest. The name is an historical misnomer. If banking were described as the business that banks typically do – receive deposits of public money – it is something that investment bankers are forbidden to do (see here for a bit more discussion on that)

What investment bankers do is:

  1. Use their own limited capital, plus such borrowing power as that capital will support, to buy such portion of a long term security issue as they can afford, and
  2. Endeavor to resell it to investors as quickly as possible.

They cannot themselves be investors, or their limited capital would be locked up and they would go out of business. Nevertheless, investment bankers are an important source of venture capital, through their contacts with institutional venture funds or sophisticated individual investors who understand and can bear the economic risks of startup capital investments. Investment bankers may also serve as advisors in the structuring of the financing even if no involved in raising the venture capital.

Essentially, an investment banking firm is a combination of people of two different kinds — people with capital and people with a great deal of initiative and enterprise. Their primary business is to suggest to a startup a form of publicly issues security by which it can raise capital better than through a sale to institutional investors or to its own shareholders. Because the startup wishes to be assured of the money, the investment banker’s suggestion  must carry with it an undertaking to a) use his own capital to underwrite a portion of the issue and b) to find among other investment bankers additional so-called participants in the underwriting in sufficient number to purchase in the aggregate the whole issue.

Many investment bankers are not willing to undertake a small private financing through individual investors because of the high due diligence responsibilities and corresponding securities law liabilities. Unless the financing involves several million dollars, there may not be sufficient sales commissions and other fees to justify the due diligence responsibilities and securities law liabilities of the investment banker. For this reason, many investment bankers will only solicit financing from professional venture capital funds who usually perform their own due diligence, relieving the investment banker of such responsibility and corresponding liability.

If a startup appears to have such growth potential as to require additional private and/or public financing within a relatively short period of time, an investment banker may be willing to raise the initial capital so as to position itself to handle the later stage financing, including the initial public offering which is more lucrative in commissions, underwriters’s warrants and consulting fees.

Investment bankers typically charge three types of fees:

  1. Cash retainer fee — payable either as a lump sum upon execution of the engagement letter, or over a period of months.
  2. Success fee — payable upon closing of the financing for which the investment bankers were retained. It is typically a percentage of the amount of financing raised and varies whether the financing is equity, subordinated debt, or senior debt.
  3. Warrants – often investment bankers request warrants to purchase common shares, usually at an exercise price equal to the same price the outside investors are paying in the subject financing.

Exit Strategies for a Startup (via Pinsky Law, “Startup and Business Law Resources“)

The typical exits for startups include IPOs, mergers/aquisitions and bankruptcy. The IPO was especially popular during the height of the Internet and technology boom, the time when numerous relatively newly formed companies went public. Typically less than one startup in 1,000 ever goes public. Those with venture financing have a much better chance — one in ten, yet sixty percent of venture-funded startups go bankrupt.


One Response to “Banks!”
  1. dem says:

    I think it’s interesting the comment about how hard it is for internet and other high-tech startups to get a loan from a traditional bank because they lack what the bank deems adequate collateral — even though one could also posit that the banks’ notion of value is outdated. (Or perhaps just despairingly practical, given the statistics about success rate of start-ups…)

    But it does explain why I feel like I never heard of venture capital etc. until we started Tripod during the mid-90s Internet boom — it probably just wasn’t as common then, as much a part of mainstream culture, as it has become in the last 20 years.

    Oh, also to remember that we should get in touch with my old boss/CEO of Tripod, who’s now a venture capitalist in the Berkshires. Maybe while we’re in residence at Williams?

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