What’s the difference between lenders and investors?
9 minutes read
Here’s a typical path for many early-stage firms. The company is seeking funds to scale, grow or develop a new business line. The first instinct is often to prepare a pitch for equity financing from venture capital or other investors.
At some point, the company hears about the benefits of debt financing. A loan is non-dilutive, usually cheaper than equity and preserves control. It’s also generally available more quickly and can come with flexible repayment terms.
Almost as an afterthought, the company decides to apply for a working capital loan, either in place of or in conjunction with an equity round. Businesses frequently send lenders the same pitch they sent to potential equity investors. This is where problems often arise.
Lenders want to see a solid business case based on detailed and realistic forecasts.
Lenders want to see proof they will get repaid
In my work with BDC’s Technology Group, I see loan applications like this all the time. A company has an exciting pitch about an innovative product and rosy projections for rapid growth.
The problem is lending institutions are unlikely to accept such a pitch as the basis for extending a loan. Some adjustments will be required because a lender looks at your business very differently than an equity investor.
What lenders want to see is a solid business case based on detailed and realistic cash flow forecasts that show how the loan will benefit the company and get repaid.
This is very different from a pitch to equity investors where the focus is on the potential upside.
Many entrepreneurs surprised
An investor wants to buy into a company with soaring growth potential, hungry founders and an inspiring story and pitch. These are the elements that founders sometimes develop with the help of accelerators and incubators.
Lenders have a different priority. They want to get their money back. Growth is great, but ensuring the company has the means to repay the loan is what matters the most.
It might seem obvious that lenders and investors don’t have the same priorities, but many entrepreneurs are still surprised when a lender requests different information than what was used to entice an investor.
Entrepreneurs should tailor forecast to lenders
In my work at BDC as a resource for tech companies preparing loan applications, I find that the key document usually needing a second look is their financial forecast. Many entrepreneurs initially present a forecast that is overly optimistic. We use the forecast to tailor the repayment terms of the loan, so we want to be sure that the projected cash flows are as realistic as possible.
The fact is that forecasts are important not only for a loan application, but also for running your business. They show ups and downs in your cash flow and help you anticipate when you could be short of funds to pay bills or payroll.
Projections prepared for an equity investor often stretch out to five years and are broken down by year. For lending and internal business purposes, projections should be broken down by month and go out one or two years.
If your projections show 20% growth month over month, but no investments to account for this, you can expect questions about how you got the numbers.
Differences when pitching to lenders and investors
|The pitch||Needs to be exciting with a focus on growth potential, hungry founders and an inspiring story.||Want to see proof that the company has the means to repay the loan. Should include a detailed and realistic cash flow forecast, as well as accountant-reviewed financial statements or a tax assessment for the previous year.|
|Financial projections||Often stretch out to five years and are broken down by year.||Projections should be broken down by month and go out one or two years. Should adjust for seasonality and scenarios.|
How to prepare financial forecasts for lenders
Businesses often prepare highly optimistic projections for investor pitches to show the market potential. Lenders, on the other hand, want to see realistic projections. This is especially so if the loan isn’t secured and is based on historical and projected cash flows.
We look at how the forecast aligns with past financial statements and the investments and projects that the company tells us it wants to pursue. The forecast should realistically and clearly show how the business expects the new funds to impact future cash flows and growth.
What does “realistically” mean? If your projections show 20% growth month over month, but no investments to account for this, you can expect questions about how you got the numbers.
Include seasonality and scenarios
Investments often cost more and take longer than expected and need time to start paying off. Realistic projections should factor this in. They should also reflect when cash inflows and outflows actually happen, not when a sale is made.
Many businesses have an element of seasonality. This should also be included to give lenders an idea of how the company will bridge seasonally lean periods.
It’s also useful to see various scenarios—one forecast with debt and equity financing (if any is anticipated), and a second one with no extra funding. This helps the lender see how the lights stay on.
Projections help structure repayment
Having realistic projections shows lenders the entrepreneur is diligent and has thought through the benefits of the debt and what it will do for their business.
Realistic projections are also important for another vital reason. They help a lender structure the loan to match repayment to anticipated cash flows. Flexible repayment terms can include an initial interest-only period, step payments based on expected growth or a balloon payment based on a planned venture capital round.
And because lenders are usually long-term partners for a business, there’s a good chance the entrepreneur will be back to ask for another loan in the future. Lenders will then review past forecasts to check how realistic they turned out to be. If anything, we like to see a forecast being overachieved. Falling short, on the other hand, can impact a company’s credibility and subsequent financing.
What documents do I need to prepare a loan request?
Cash flow projections are key for lenders, but they’re not the only document we need to see for loans. At BDC we also require:
- CPA-prepared financial statements for the latest year-end, or a tax return and notice of assessment from the Canada Revenue Agency
- Internally prepared financial statements for the current year to date
- A written or verbally presented business plan (depending on the financing)
Many growth-focused business owners are understandably so busy that daily chores like bookkeeping may get neglected. I know; I was an entrepreneur myself. But preparing projections and other key business documents can pay off significantly with superior decision-making, strategic focus and financial soundness.
Essential to get to next level
Projections may reveal that your company needs more financing than expected to cover gaps in working capital. They could show that an investment has a poor return and should be reviewed.
And they can help you weigh the pros and cons of debt vs. equity financing early on when designing your funding roadmap.
The fact that lenders require this kind of homework is almost incidental. Businesses should do it for themselves, even if they’re not seeking financing. It is the essential groundwork that can help you take your company to the next level of success.