Startup loans: how can banks deal with their high credit risk?

Startup loans: how can banks deal with their high credit risk?

Why it is smart to start investing in the stock market?

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Should I be a trader to invest in the stock market?

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What app should I use to invest in the stock market?

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Is it risky to invest in the stock market? If so, how much?

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Tell us if you are already investing in the stock market

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With nearly 150,000 new businesses launched each year worldwide, entrepreneurship seems to have become more accessible: open source technologies and cloud storage solutions are reducing the cost of software development, remote working is gaining in popularity and eliminating office costs...Yet, funding remains the main obstacle to the development of a startup. According to a 2019 survey of 590 European startups, 32% of them find access to finance difficult. Self-funding is the main source for 66% of startups, followed by business angels and venture capital funds. Banks are absent from this podium, as they are often reluctant to offer startup loans due to their high credit risk.

Source: European Start-up Survey, PwC (2018)

Financing, a critical issue for startups

Very few startups escape the rule: high levels of capital are required to develop innovative products and solutions. It often takes several months or even years of R&D before a marketable product is developed. Thus, during its first years of existence, a startup will spend a lot of money to pay for its premises, recruit qualified employees, develop prototypes... without generating any turnover.

When they are founded, startups are often supported by organisations and structures promoting the financing of young entrepreneurs, under the impulse of government initiatives. But between two and three years of existence, new challenges arise. Scaling startups face serious financing problems even though they need it to finalise their product or accelerate their commercial development. Indeed, even if it generates revenues, a startup needs funds to enable rapid growth. It is only a few years later that it can hope to reach profitability and finance its own development.

To meet this need, many startups turn to venture capital funds or business angels. These players are used to taking risks and are aware of the particularities of startups, unlike traditional banks.

Banks are still reticent to offer startup loans

The mitigation of credit risk is at the heart of a banker's job. The bank must ensure that any borrower, whether an individual or a company, will be able to repay the loan on the due dates set out in the contract. Credit risk analysis is essentially based on financial data: in the case of a company, the bank will study the company's revenue, level of indebtedness, cash flow, etc. Unfortunately, this approach is ill-suited to startups.

As mentioned earlier, a startup needs a lot of capital to develop and it can take time to generate revenue. An early stage startup will have very little financial data to present to a bank. Moreover, at the R&D stage, it is not always clear whether the startup will be able to find clients or whether its product will be suitable for the market. Indeed, it is estimated that 90% of startups fail and only 30% of them manage to reach profitability.

In addition to this high risk, startups often lack guarantees to provide to banks. Many entrepreneurs are recent graduates or young professionals who cannot provide personal guarantees. Startups do not necessarily have physical assets to offer as collateral since nowadays many products are digital (SaaS, mobile applications...).

Faced with this reticence on the part of retail banks, public banks have put in place numerous funding programmes, which were reinforced during the Covid-19 crisis. In France, the government announced a 4 billion euro package in March 2020, while the British government decided to put 250 million pounds into a co-investment fund with private venture capital funds. Governments would now like private banks to take over by providing more loans.

Reasons for encouraging bank loans

On the startup side, loans help to limit the dilution of their capital. Founders and initial shareholders can retain control over their management by opting for non-dilutive funding. Loans can also be used as a bridge between two rounds of fundraising, enabling the negotiation of a higher valuation. There is also venture debt, which is halfway between debt and equity financing.

It can be interesting for banks to bypass credit risk and add high-potential startups to their client portfolio. Indeed, startups make up the market of the future and represent a strong potential in the long term. They might become important mid to large-sized companies with multiple banking needs: account management, international development, export... By granting them a loan, banks can thus set the foundations for a fruitful and lasting customer relationship.

Besides financing, banks can support the development of startups by offering advisory services, as HSBC and Barclays did throughout the Covid-19 crisis. They can also provide growth opportunities by connecting their business clients to their network of partners and suppliers. So, it seems essential for banks to improve their relationship with small businesses.

How to better assess the credit risk of a startup

The main obstacle to this collaboration seems to be the high credit risk of startups. The challenge is to better assess this risk, taking into account the specificities of these young innovative companies. As mentioned, relying solely on financial data does not allow for a proper assessment of a startup's growth potential. Financial data is usually insufficient, sometimes non-existent at the beginning of the project, but above all, it can paint a misleading picture of the company.

WeWork is a very telling example of the importance of considering non-financial data. Despite a turnover of more than $1bn in 2018, this coworking giant was still not profitable in 2019. The company decided to go public with a valuation of $47bn. However, investors were disappointed once internal dysfunctions were revealed and the valuation fell to $8bn. The IPO then fell through and the company suffered a series of setbacks.

To assist commercial banks and debt funds in assessing startup credit risk, Early Metrics scores 30 financial and non-financial criteria. We look at the governance of the startup, including the composition of the management team, its involvement and complementarity. In parallel, we assess the business model, the innovation of the product, and the dynamics of the target market. These criteria, refined and weighted thanks to our backtesting studies, allow us to estimate the potential of a startup.

Backtesting consists of tracking the survival and/or success of startups in our database (over 3,500 companies) 12, 24 and 36 months after the first rating. This process has also allowed us to create a reliable predictive model of the survival rate according to the sector and the stage of maturity of a startup. These analyses, therefore, provide banking players with a more comprehensive view of the risk profile of innovative startups.

Banks should not miss out on tomorrow's market leaders

Rather than seeing high credit risk as an insuperable hurdle, banks should learn to better assess the growth potential so as not to miss out on future tech stars. Knowledge is the first step towards better risk management. Banks and debt funds should therefore improve their knowledge of startup-related topics. Thanks to in-depth analyses, these debt players will be able to make informed loan decisions and contribute to the development of young companies that are driving the economy of tomorrow.

Translated from French by Julie Durban