Collapse in equity market increases requests for loan financing

In 2023 we are seeing a large increase in requests for bank financing as an alternative to equity, explains Håvard Lindtvedt – Head of the Startup & Growth segment in Norway. Companies say it is harder to attract investor capital and some see investors dropping out at the last minute. We are experiencing pricing issues as a show-stopper for agreeing on terms. As a consequence many look at loan financing as an alternative funding source short term, and hope for normal market conditions in a longer perspective.

Loan financing by nature is attractive as it will in many cases have a lower cost of capital than equity. The terms of repayment are very clear and transparent and it gives you tax benefits. Further, it does not dilute your position as an owner. On the other hand, equity involves a longer-term perspective in relation to when shareholders expect a return while loans will affect your cash flow immediately with payment of interest and principal from day one.

But is bank financing a good alternative to equity? Not always. To help decide when to contact a bank, this article gives you an insight into how we evaluate a loan request and what criteria we focus on.

Nordea’s financing principles

Nordea has provided loan financing to over 1,500 Nordic start-ups and scale-ups and has solid experience in an advisory role. A loan can boost your growth but also strangle you in a slow growth scenario. At Nordea we consequently spend much time advising you on your funding strategy to avoid any pitfalls.

What is our advice?

If a start-up is in the early stage of business operations and does not have a cash flow-producing business and no proven underlying profitability, we do not recommend loan financing. The risk of loan financing in this stage is much higher than equity, as it will mean burning cash in an already costly phase of the life cycle. Loan financing requires that a company is classified as a growth company with a marketable product/service, an existing market and proven underlying profitability.

The company’s business idea and how it makes money need to be clear and comprehensible. Also, we need to have a clear understanding that the team behind the company is competent, that is, has professional ability in core business functions. When you enter the professional funding market (venture capital firms, banks), the success rate will rise if you can point to CFO competencies and a well-argued business plan with professional and transparent financial models.

As a main rule the company needs to be profitable on EBITDA level and produce enough cash flow available to service debt (CASD). However, in most cases companies burn cash for a period and we can accept negative EBITDA if the following three requirements are met:

• Strong existing liquidity so that there is a sufficient buffer to cover the negative cash flow up to the expected breakeven. Commitments from owners/investors to support liquidity will be taken into account when assessing whether liquidity is sufficient.
• Forecasts need to be solid, realistic, partly proven/underpinned by actual sales or order book, and the underlying assumptions must be strong and well documented.
• The company should be profitable on EBITDA level within two years.

This means that you have to demonstrate the ability to attract more capital in a stress scenario where you run out of cash earlier than planned. If the existing owners do not have the willingness or capacity supplement with additional capital, the risk is very high in today’s market.

You need to show repayment capacity as regards the loan and have a well-documented growth plan. Some will say that this looks like an investor deck or a financial due diligence process. And shouldn’t applying for a loan be a much smoother process? Most companies are surprised at how the bank deep dives into their numbers, so keep in mind that most processes take longer than you expect. And remember that banks have full confidentiality, so be as transparent as you can when it comes to risk elements.

Many companies ask for loan financing to bridge a planned equity round. This is understandable from a founder’s point of view when they need more time to increase the value of the company and become more attractive for the equity market. It should be noted that the main rule is that the necessary equity is invested in the company before the bank enters into any debt financing. As an exception, equity may be invested at a later stage if there are legally binding commitments from the owners/investors to inject additional equity when needed, and we have documentation of their ability to honour their commitments. In today’s market this risk is sky-high and must be very well verified before we enter into loan financing as a bridge to equity.

Apart from a realistic base case we should be presented with a slow growth case. An analysis of our Nordic loan portfolio of around 1,500 start-up companies shows that over 70% of the cases underperform. We will normally have a conservative approach towards add-on financing in cases where performance has been weaker than forecast. It is the owners’/investors’ role to provide the financing needed until the company is back on the forecast base case that was presented when we granted the credit.

Wrapping it up

We are seeing a large increase in loan requests and many companies obtain loan offers from us. Loan financing is increasingly more accepted as a funding source, also from venture capital firms as owners.

- I think that our tailor-made loan solutions and our close relationships with the venture capital firms in Norway and the Nordics provide a good set-up for growth. Together with the companies we can define a healthy capital strategy and structure in line with the owner’s risk appetite, says Lindtvedt.